The Oil Price Collapse Separates the Wheat from the Chaff
The price collapse caused by the Covid-19 pandemic and the disintegration of the OPEC+ alliance will lead to a major restructuring of the already-struggling North American upstream space through extensive bankruptcy filings and consolidation. Consultancy Rystad Energy estimates that 70+ US E&Ps could file Chapter 11 in 2020 if $30 WTI persists, with this number doubling to 140 at $20 WTI.
The first victims are likely to be high-cost operators in geographically disadvantaged areas where the cost of getting barrels to market is high – the Bakken, DJ, PRB and Uinta Basins and Albertan oil sands. We’ve already begun to see this with Whiting Petroleum’s Chapter 11 filing last week and EP Energy’s filing last Fall. Independent producers who have recklessly chased meaningless, credit-fueled production growth at the expense of FCF will be similarly culled, regardless of location.
However, with this turmoil comes great opportunity. As the saying goes, “There’s no better cure for low oil prices than low oil prices.” In response to the distressed environment, we’ve already seen US and Canadian producers strip-out $40 billion of capex from their 2020 budgets. This will lead to immediate and sizeable declines in output from US shale, as those familiar with the hyperbolic decline profile of shale wells will already know. Declines from peak production (typically M2 or M3) to M12 are frequently 70% or higher. In other words, when drilling stops, production craters.
The lack of sanctioned non-OPEC, ex-US projects coming online over the next few years will further accentuate the coming structural supply deficit. In our estimation, we are due for a sharp recovery in oil prices by 2022, with WTI prices likely to rise above $70/bbl. The below graph from Goldman Sachs shows the shortfall of sanctioned projects over the coming years:
Low-cost and low-leverage North American producers that remain solvent during this difficult period will therefore be well-positioned to capitalize on the inevitable market rebalancing. Despite its misguided hedging policy, we believe Cenovus Energy fits this description and offers a very attractive medium term (2021-2022) risk-reward profile for investors who can stomach short term volatility.
Lack of Hedging Stings; Offers Upside Exposure for Risk-On Investors
With WCS (FOB Hardisty) currently trading below $4/bbl, investors will rightfully question whether Cenovus can remain a going concern in 2020, particularly given its visceral distaste for hedging developed after experiencing loses on hedges of $1.6 billion in 2018.
In its 4Q19 results call this February, the company said in response to a question on hedging: “We’ve been really clear on how we think about hedging. We have said emphatically that the balance sheet is the right way to manage commodity price volatility… we still believe that. We don’t believe that a hedge program is the right way to handle commodity price volatility.”
At Cattle Drive Capital, we fundamentally disagree with this approach. In our view, not protecting a baseline price for a certain portion of your underlying production is akin to speculation. Capital budgets are underpinned by certain commodity price assumptions against which a company should hedge. In the company’s defense, the WCS-WTI differential may be relatively illiquid and costly to hedge. This, however, does not excuse it from failing to hedge the more important component — WTI flat price.
The one silver lining from this risk management misstep? Investors who have a constructive view of crude prices can pick-up Cenovus at 25% of book value and participate directly in the price recovery.
Balance Sheet & Liquidity Sufficient to Survive 2020
A quick examination of the company’s balance sheet and liquidity leads us to believe that despite serious structural headwinds and a lack of hedging, Cenovus will be able to weather this year’s storm.
In a depressed price environment, the first place we tend to look is short-term debt maturities. Cenovus’ $196 million due in 2020 is manageable, particularly given its liquidity of $4.4 billion, inclusive of committed credit facilities. The company’s current ratio of 1.3 is similarly reassuring, with near-term liabilities covered by current assets, though the cash position is lower than we would like.
The company has also taken quick action in response to the price collapse, cutting capital spending by 32% and suspending its crude-by-rail shipments. Despite lower spending, production guidance was only marginally impacted, falling 6% from end-2019 guidance.
For investors who can stomach short-term volatility and want direct exposure to oil prices to benefit from the medium-term price recovery, Cenovus looks like an attractive buy at just 25% of book value. The lack of a structured hedging program — while a serious risk-management faux-pas in our eyes — is sufficiently offset by low marginal production costs, manageable short-term liabilities and a strong management focus on maintaining balance sheet strength. 2020 will undoubtedly be a painful year for Cenovus in terms of cash flow and, as such, we believe the speed of the recent share price recovery to be a bit aggressive. But for investors who can stay the course for several years, buying Cenovus at these distressed levels could lead to significantly outsized returns on the dual effects of a rally in WTI prices and a narrowing of WTI-WCS differential.
Disclosure: I am/we are long CVE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.