Before the coronavirus pandemic materialized, Cenovus Energy’s (NYSE:CVE) management had been highlighting the company could pay its dividend and grow its production at WTI prices above US$45/bbl.
After having reduced its costs and suspended its dividend to face the coronavirus-induced depressed oil prices over the last few months, the Canadian oil sands producer even lowered its breakeven WTI prices to US$38/bbl.
Since then, WTI prices partly recovered and have been staying above US$40/bbl over the last several weeks. But even if WTI prices keep on rising above US$45/bbl, investors should not expect the company to restore its previous dividend anytime soon.
Image source: Cenovus.com (Foster Creek oil sands project)
Note: All the numbers in the article are in Canadian dollars unless otherwise noted.
Challenging first-half results
Surprisingly, in the context of challenging oil prices since March, Cenovus increased its H1 production compared to the prior-year period.
Source: Q2 2020 MD&A
The company produced 474,005 barrels or equivalent per day (boe/d) during H1, up 6% year over year, as it ramped up its oil sands production in June thanks to improved WTI prices and WTI-WCS differentials. Oil sands represented 80.2% of total H1 production.
But despite this higher production volume, adjusted funds flow plunged to negative C$608 million during the first half of the year, down from C$2.1 billion one year ago because of depressed oil prices, lower refining throughput, and volatile blending costs.
Adjusted funds flow will improve as the coronavirus situation settles and oil prices recover. For instance, with narrowing WTI-WCS differentials and lower condensate prices (Cenovus buys condensate to allow its oil sands to be transported in pipelines), management indicated during the earnings call free funds flow (adjusted funds flow minus capex) exceeded C$290 million in June.
Yet the company’s net debt increased from C$6.5 billion at the end of last year to C$8.2 billion at the end of June (up C$1.7 billion in just six months) as WTI prices and WTI-WCS differentials averaged US$37.01/bbl and US$16.00/bbl.
Source: Presentation July 2020
As a result, Cenovus’ net debt ratios worsened in a significant way.
Source: Q2 2020 MD&A
Priority on reducing the debt load
Until the beginning of this year, the company was aiming at reducing its net debt, increasing its production, and paying a dividend as WTI prices stayed well above US$45/bbl.
But given the sudden increase in the company’s net debt and the volatile oil pricing environment, management seems to have changed its view on the dividend.
Moreover, Cenovus will face maturities of almost US$1 billion on unsecured notes in 2022 and 2023, which could lead to unfavorable refinancing conditions if oil pricing doesn’t improve by that time.
As a result, during the Q2 earnings call, CEO Alex Pourbaix expressed the intention to prioritize the company’s net debt reduction to C$5 billion before paying a dividend:
We remain committed to getting net debt down to $5 billion or below over the longer term.[…] Absolute priority is the balance sheet until we get that debt back down to a level that we’re a lot more comfortable with.”
And CFO Jon McKenzie confirmed:
We are laser-focused on generating free cash flow through the next few months and applying that to the balance sheet before we consider reinstituting the dividend.”
The previous quarterly dividend of C$0.0625/share represented a cash outflow of C$307 million the company can now use to reduce its leverage. But Cenovus must generate C$3.2 billion of free funds flow before its net debt shrinks to C$5 billion.
As a comparison, free funds flow exceeded C$2.5 billion in 2019 in a much favorable environment as WTI prices and WTI-WCS differentials averaged US$57.03/bbl and US$7.15/bbl, respectively.
Also, some of the measures management implemented to reduce the company’s sustaining costs and increase its free funds flow don’t seem to hold in the long term. In Cenovus’ latest presentation, the slide below shows oil sands assets’ sustaining costs should increase from approximately C$3/bbl in 2020 this year to about C$6/bbl over the long term.
Source: Presentation July 2020
In addition, during the earnings call, CFO excluded the possibility of asset sales to accelerate the company’s deleveraging. It insisted on the value of ownership interest in refining operations in the U.S. with ConocoPhillips (NYSE:COP). And it confirmed it would not sell the company’s Deep Basin assets in the currently unfavorable environment.
Given these elements, paying a dividend before reducing net debt to C$5 billion would significantly increase risks of refinancing in unfavorable conditions over the next few years. And Cenovus’ second-quarter earnings call indicates the company seems to have shifted its priority in paying a dividend.
Dividend-oriented investors may be disappointed by this outcome – the previous dividend would now yield 3.7%. However, I view those choices as prudent capital allocation decisions in a context that remains volatile and uncertain.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.