Tag: CVE

The MEG sweepstakes, revisited

You know you’re starting to get old when you consistently start reciting your own work from years on back.

Does anybody remember Husky Energy (now consumed by Cenovus Energy) tried to take out MEG Energy at $11/share in 2018?

Subsequent to this, I wrote about MEG’s pending takeover in May and December of 2021 where I speculated that Cenovus was the most likely strategic acquirer of MEG Energy. There are significant synergies with the acquisition, including geographical ones (Cenovus and MEG Energy are side-by-side at Christina Lake, Alberta):

(MEG is on the north-eastern end of the lake, CVE is on the southern and northern end, and CNQ is on the southwestern end)

For those unaware, these oil sand assets are the crème de la crème of the Alberta oil sands – they have the best steam-to-oil ratios out of all the oil sands. As most of the capital has already been spent on the projects, they will be generating cash flows for decades. It cannot be understated how valuable this asset is whether oil is trading at 50, 75 or 100 a barrel – they are the lowest cost production fields in North America.

Indeed, I wrote those articles when MEG was $12/share and my very pithy analysis speculated that one of CVE or CNQ would just do a 30-40% premium buyout and get it over with. This would have been about $17/share equivalent. The only element that has changed since then (the commodity price environment round-tripped after the Russian invasion of Ukraine, and when adjusting for Canadian currency and the narrower WCS differential the price is virtually the same today as it was back then) is the price being paid – roughly speaking, $5.2 billion in cash and 84 million shares of CVE for a grand total of about $7.2 billion at today’s market value of CVE or about $28/share for MEG.

This is a very unusual transaction considering that Strathcona’s offer was originally higher than Cenovus’ offer, but the even more shocking factor to me is that Cenovus is trading higher after delivering a lower bid than Stratcona, which MEG agreed to!

I wasn’t expecting this set of circumstances to be on my bingo card.

When running my paper napkin calculations, it will be a synergistic acquisition. Just looking at an apples-to-apples comparison in 2024, CVE trades at 11x EV/FCF, while MEG trades at 10x – this is using the currently elevated share prices at August 27, 2025.

There are other synergies – there are plenty of greenfields in the MEG geographical footprint to facilitate the maintenance of their SAGD projects, TMX allocation, and tax shield assets which will deliver quite a bit more cash flow to the underlying Cenovus entity (not to mention the cost elimination of a management layer). The CVE cash portion will be funded by low cost (and tax deductible) debt and the leverage situation after the acquisition is still modest. Finally, MEG in the end of 2024, in an attempt to appear relevant, announced they would spend about half a billion dollars in what they titled a “Facility Expansion Project”, adding 25,000 boe/d of production in a few years – presumptively this project will be canned as half a billion dollars is one hell of an opportunity cost when you have a limited geographical footprint like MEG did (not to mention egress issues).

Strathcona will also get a tactical victory by virtue of its short-term investment in MEG paying off, but strategically they are still looking for ways to tap into the very valuable market of having enough of a stock float to be picked up by index ETF investors – I am absolutely sure they will be on the prowl in the oil patch to boost their own liquidity. At this point the only other obvious target that is publicly traded is Athabaska Oil Sands (TSX: ATH), but they’ve received too much of a bid recently in anticipation of exactly that.

What is ahead in the Canadian fossil fuel industry?

From a broad strategic perspective, the next logical merger would be Cenovus and Suncor. The major synergy here is with the refining networks both companies have – internal consumption of your own product hedges against the inevitable egress risk that will be coming up later this decade. Irvine, Valero, Shell and Imperial Oil would still be primary competitors in the refining space.

Modelling commodity companies

I’m not much of a technical analysis guru but here is my depiction of the trendline of Cenovus Energy (TSX: CVE):

Will this go on forever and end the year at $70/share? I wish, but incredibly unlikely unless if we’re heading into Weimar Republic inflation.

Despite this price rise, the company is still relatively cheap from a price to free cash flow metric. You don’t need to have a CFA in order to do some basic financial modelling:

This is from their IR slides and they will be spending $4.8 billion on capital expenditures in 2024. At “Budget”, which is WTI US$75, and US$17 differential to WCS pricing, the company will do roughly $10 billion in operating cash flow, leaving $5.2 billion of it free. They also have a sensitivity of $150 million per US$1 of WTI.

Everything being equal (it is not, but this is a paper napkin modelling exercise), at today’s closing price of WTI at US$86.75, they’re looking at a shade just under $7 billion in free cash flow. It won’t be quite this high in reality, but that puts the company at around 8.5xFCF to EV even at the current price. If you were smart enough to buy it at $20/share back in mid-January, at the price of WTI then (US$72/barrel), your FCF to EV ratio would have been… about 9x.

In other words, the price appreciation is strictly a result of the commodity price improvement, coupled with a very small multiple decline (which the truer computer models out there which algorithmically trade all these fossil fuel companies on a formulaic basis perform).

For the fossil fuel components in my portfolio, I have pretty much given up on any other smaller companies other than the big three (CNQ, CVE and SU) simply because I have little in the way of competitive advantage to determine which one of the smaller companies have better on-the-ground operations and superior geographies to work with. They all trade off of the commodity curve one way or another. The “big three” are low cost producers and will generate some amount of cash going forward, barring a Covid-style catastrophic environment.

They are basically the equivalent of income trusts at the moment. Remember the old Canadian Oil Sands (formerly TSX: COS.un) before it was absorbed into Suncor? That’s exactly that these three companies are – they all have gigantic reserves and very well established low-cost operations, and capital allocation that is simply going to dump cash out to dividends or share buybacks.

Risks inherent with all three:
1. A common regulatory/governmental risk being located in Canada, and mostly Albertan operations.
2. Fossil fuels may be subject to displacement if we actually see some sort of renaissance on nuclear power (there are whiffs of it here and there, but going from speculation to reality is another matter entirely).
3. The usual cyclical supply/demand factors.

With point #3, I see in the presentation decks of most of these companies (especially the smaller ones) that they are very intent on increasing production. Despite the fact that TMX is going to be operational in a month, the egress situation out of Canada will once again saturate. No more refineries are being built and thus the demand-supply variable will likely push WTI-WCS differentials higher at some point in the near future. With balance sheets of all the companies stronger than they ever have been, there will likely be some “race to the bottom” effect coming in due course, similar to how the domestic natural gas market has been saturated – both AECO and Henry Hub commodity pricing are quite low and LNG export pricing is back to its historical levels (around US$9.50/mmBtu spot).

I think what will happen is that the higher capitalization companies will use their relatively stronger balance sheets to pick away at the entrails of the smaller, higher leveraged operations when the price environment goes sour. Given the overall under-leveraged bent most of these smaller companies have been taking as of late, this process going to take awhile and a lower commodity price environment to achieve. These are not “forever hold” companies, but certainly at present their valuations continue to look cheap.

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.