Refinery explosions

Oil refineries are incredibly complex pieces of machinery.

I’ve read the technical report at the now-Cenovus, formerly Husky Superior refinery that occurred in 2018 (this was before Cenovus took over Husky).

If you ever want to get a sense of appreciation at the technological marvel of oil refining, you should read this report.

This refinery is currently being rebuilt and should become operational again sometime this year.

Cenovus has had bad luck with their refineries. About a month after they signed a deal to acquire the remaining 50% of their Toledo refinery (the other 50% is owned by BP and the refinery is operated by BP), the refinery blew up on September 20, 2022 which resulted in the death of two workers. Thankfully for Cenovus, it was before the deal actually closed, and one would presume that the acquisition contact would require the refinery to be in a non-blown up state before the deal closes.

The preliminary report, released on October 31, 2022, indicates that a release of flammable materials from a specific drum was the origin of the fire.

These investigations take a lot of time and I do not think the repair job will be a speedy process either. It is too bad for Cenovus, as refinery spreads are sky-high at the moment and considering the lack of capacity expansion on downstream operations, will likely be this way for some time.

A few miscellaneous observations

The quarterly earnings cycle is behind us. Here are some quick notes:

1. There is a lot more stress in the exchange-traded debenture market. Many more companies (ones which had dubious histories to start with) are trading well below par value. I’ve also noticed a lack of new issues over the past six months (compared to the previous 12 months) and issues that are approaching imminent maturity are not getting rolled over – clearly unsecured credit in this domain is tightening. There’s a few entities on the list which clearly are on the “anytime expect the CCAA announcement” list.

Despite this increasing stress in the exchange traded debenture space, when carefully examining the list, I do not find anything too compelling at present.

2. Commodity-land is no longer a one-way trade, or perhaps “costs matter”. I look at companies like Pipestone Energy (TSX: PIPE) and how they got hammered 20% after their quarterly release. Also many gold mining companies are having huge struggles with keeping capital costs under control. Even majors like Teck are having over-runs on their developments, but this especially affects junior companies that have significantly less pools of financial resources to work with (e.g. Copper Mountain).

3. This is why smaller capitalization commodity companies are disproportionately risky at this point in the market cycle – we are well beyond the point where throwing money at the entire space will yield returns. As a result, larger, established players are likely the sweet spot on the efficient frontier for capital and I am positioned accordingly. I note that Cenovus (TSX: CVE) appears to have a very well regulated capital return policy, namely that I noticed that they suspended their share buybacks above CAD$25/share. The cash they do not spend on the buyback will get dumped to shareholders in the form of a variable dividend. While they did not explicitly state that CAD$25 is their price threshold, it is very apparent to me their buyback is price-sensitive. This is great capital management as most managements I see, when they perform share buybacks, are price insensitive!

4. Last week on Thursday, the Nasdaq had a huge up-day, going up about 7.3% for the day. The amount of negative sentiment baked into the market over the past couple months has been extreme, and it should be noted that upward volatility in bear markets can be extreme. This is quite common – the process is almost ecological in nature to flush out negative sentiment in the market – stress gets added on to put buyers and short sellers and their conviction is tested. Simply put, when the sentiment supports one side of a trade, it creates a vacuum on the other side and when there is a trigger point, it is like the water coming out of a dam that has burst and last Thursday resembled one of these days. In the short-term it will look like that the markets are recovering and we are entering into some sort of trading range, but always keep in mind that the overall monetary policy environment is not supportive and continues to be like a vice that tightens harder and harder on asset values – and demands a relatively higher return on capital.

I suspect we are nowhere close to being finished to this liquidity purge and hence remain very cautiously positioned. My previous posting about how to survive a high interest rate environment is still salient.

Cenovus Energy Q3-2022 – quick briefing note

Cenovus (TSX: CVE) reported quarterly results.

The salient detail is that in addition to spending $2.6 billion in share buybacks and dividends, they are able to get net debt down from $9.6 to $5.3 billion for the 9 months. Specifically they have $8.8 billion in debt and $3.5 billion in cash.

They have a framework that gives off half the excess cash flow to buybacks and variable dividends. For Q3 this was allocated 75% to buybacks and 25% to the variable dividend.

In the conference call they alluded to this mix depending on the projected returns on the equity, which suggests a price sensitivity to their stock price.

This is exactly how they should be thinking. There should be a point where they stop buying back shares and instead just give it out in cash. At CAD$28/share, that point is getting pretty close.

They have a stated objective of dumping half their excess cash flow into their framework, and once net debt heads below $4 billion, then it becomes all of their excess cash flow. This should happen by the end of Q4.

While I believe a 100% allocation is not the wisest (they should top it out at 90% and focus on eliminating the debt entirely), given the maturity structure of their outstanding bonds, there is zero term risk in the next decade and a half (with their existing cash balances they can tender out the rest of their debt until 2037).

Once they start distributing 100% of their excess cash flow to dividends and buybacks, Cenovus will effectively function as an income trust of yester-year where you had Penn West and Pengrowth consistently giving out cash distributions. The buyback algorithm should auto-stabalize the stock price. At US$90 oil and refining margins sky-high and with little signs of abatement, Cenovus is on track to generating $8 billion in free cash flow for the year. Very roughly, that is about 14%/year and this is much higher than I can recall the historical income trusts yielding.

Unless if the stock price gets ridiculously high, or if management starts to display capital management that is off-colour (i.e. going on acquisition sprees that do not make sense), this is going to be a core holding for a very long time. It is too expensive to buy and too cheap to sell, so I look forward to collecting the cash distributions where I will try to find a better home for.

Diversification

There are events that you just can’t predict, such as having to deal with malware on your web server.

This week has been full of them, and it is only Wednesday.

Teck (TSX: TECK.B) announced on the evening of September 20 that their Elkview coal plant (their major metallurgical coal operation) had a failure of their plant conveyor belt and it would be out of commission for one to two months. If out for two months, this would result in a loss of 1.5 million tonnes of coal. Considering that they can get around US$400/tonne for their product, and very generously they can mine it for US$100, this is a huge hit. Not helping is that one export terminal (Westshore (TSX: WTE)) is going on strike, but fortunately Teck managed to diversify from this operation last year with their own coal loading terminal!

Cenovus (TSX: CVE) owns 50% of a refinery in Toledo, Ohio. BP owns the other half, and they are the operating partner. There was a story how a fire at the plant resulted in the deaths of two workers, and the refinery has been shut down to investigate. Making this more complicated is that on August 8, 2022, Cenovus announced they will be acquiring the other 50% of the refinery for US$300 million in cash. Ironically in the release, it is stated “The Toledo Refinery recently completed a major, once in five years turnaround. Funded through the joint venture, the turnaround will improve operational reliability.

Given the elevated level of crack spreads and the 150,000 barrel/day throughput of the refinery, the cost of this fire will not be trivial, and quite possibly will involve an adjustment to the closing price.

The point of these two stories is that there can be some one shot, company-specific event that can potentially affect your holdings – if there are other options in the sector you’re interested in investing in, definitely explore them and take appropriate action. Teck and Cenovus are very well diversified firms, but if you own an operation that has heavy reliance on a single asset (a good example would be when MEG Energy’s Christina Lake upgrade did not go as expected a few months ago), be really careful as to your concentration risk of such assets.

On a side note, have any of you noticed that many, many elevators are out of commission in publicly-accessible buildings? It’s like expertise in anything specialized is simply disappearing – it makes you wonder whether the maintenance operations of the above companies (and many others not listed in this post) are being run by inexperienced staff.

Cenovus Energy’s relatively small dividend

Cenovus Energy (TSX: CVE) is Canada’s second largest oil producer (behind CNQ), featuring two flagship oil sands projects, Christina Lake and Foster Creek. Unlike CNQ, they have downstream capacity just a shade short of their production levels. Needless to say they have been producing a lot of cash flow.

Compared to the top three (CNQ, Suncor and CVE), Cenovus’ dividend has been relatively paltry – the yield has been less than 2% and a very small fraction of the company’s free cash flow.

You might have been wondering why, and it likely concerns the warrant indenture. Specifically, the warrants have a price adjustment if “Dividends paid in the ordinary course” exceeds a certain level:

in the aggregate, the greater of: (i) (a) for the 2021 financial year, $170 million; and (b) for financial years after 2021, 150% of the aggregate amount of the dividends paid by the Corporation on its Common Shares in its immediately preceding financial year which were Dividends Paid in the Ordinary Course for such preceding year;
(ii) 100% of the retained earnings of the Corporation as at the end of its immediately preceding financial year; and
(iii) 100% of the aggregate consolidated net earnings of the Corporation, determined before computation of extraordinary items but after dividends paid on all Common Shares and first preferred shares of the Corporation, for its immediately preceding financial year, in each case calculated in accordance with Canadian generally accepted accounting principles consistent with those applied in the preparation of the most recently completed audited consolidated financial statements of the Corporation;

The relevant clause for 2021 is retained earnings, and it was $878 million at the end of 2021. $878 million divided by 2.016 billion shares outstanding gives you about 43 cents per share, and CVE’s current dividend was raised to 42 cents per share.

For the first half of 2022, retained earnings is sitting at $4.6 billion and this will likely go much higher by year-end. At June 30, CVE had 1.97 billion shares outstanding and thus they can practically increase their regular dividend to match their cash flow once the audited financial statements are released in March of 2023. Until then, they are stuck with their existing dividend and are busy buying back shares and paying down debt in the meantime, in addition to consolidating the 50% share in the Sunrise oil sands and Toledo refinery that they previously did not own. Once they get down to their $4 billion debt target, the company pledged to distribute 100% of its earnings to shareholders – practically behaving like an income trust if you remember those days when Penn West and Pengrowth income trusts were throwing out the cashflow in a similar manner. An annualized $2/share dividend is not out of the question, and this would likely result in the stock trading for higher than what it is currently trading for today.