The Market Is Missing Cenovus' Potential

Although oil sands costs have drastically decreased over the past two years, most expansion projects still aren’t economic at our midcycle forecast of $55 per barrel of West Texas Intermediate; thus, they struggle to compete economically with other global supply sources. However, it appears that

Cenovus Is Positioned to Reap the Benefits of SA SAGD Testing Given their position near the upper reaches of the industry cost curve, oil sands operators have long been exploring ways to reduce costs. It appears that Cenovus has found a way to do so, and we expect it to lead the charge in cost reductions. Cenovus' SAP technology has been at the forefront of SA SAGD-- solvent-assisted steam-assisted gravity drainage--pilot testing, and its success looks to be the catalyst needed to tap the company's vast resource potential. The company has been operating its SAP pilot at its Christina Lake project for five years, and results have been encouraging. To date, the pilot has operated with a 30% lower steam/oil ratio, 10% lower sustaining capital and nonfuel operating costs, lower emissions and water use, and a smaller land footprint than traditional SAGD extraction. The pilot has also experienced a 15% increase in field recovery rates, which decreases initial capital outlay per barrel.

Wider implementation of the technology is still a few years away. In the meantime, we expect SAP to be a major topic of Cenovus’ conversations. In the coming months, we expect the company to provide an update on its Narrows Lake greenfield project, which will be the first of many SAP expansion projects. A project update from Cenovus will be a testament to the technology’s potential.

Cost Reduction Looks Realistic and Meaningful Using current SAGD extraction techniques, Cenovus' Christina Lake and Foster Creek brownfield expansion projects currently require WTI prices in excess of $55/bbl and $65/bbl, respectively, to economically break even. However, SAP's cost structure paints a more optimistic future.

With SAP, we expect Cenovus to lower the energy intensity required on expansion projects. Energy and water use, which plagues the SAGD operating cost structure, is expected to decline by 30%. Not only does lower energy intensity and water use lower operating expenses, but it has a trickle-down effect that lowers other costs: up-front capital requirements, plant operating expenses, and chemical costs. Further lowering the cost structure is the expected 15% increase in field recovery rates, which reduces the number of wells needed to reach nameplate capacity along with annual sustaining well pads, routine maintenance and repair, operating workforce, and initial capital outlay per barrel.

Also, Cenovus’ SAP extraction method is expected to produce higher-quality, less-viscous oil, which very likely will improve bitumen price differentials by as much as 10%-15%. Heavier metals that accompany today’s SAGD production are left in the ground with SAP extraction. As a result, the extracted bitumen is expected to be produced as pipeline ready or near so, which meaningfully lowers the blending requirements present in current SAGD production. Due to their fixed nature, we expect transportation costs to be lowered by more than 15% as more bitumen and less blending agents are shipped through the pipeline (spreading a fixed shipping cost over more barrels of bitumen). With SAP extraction on its brownfield expansion projects, we expect Cenovus’ project break-even prices to fall to $45/bbl and $55/bbl WTI at Christina Lake and Foster Creek, respectively.

Cenovus’ Narrows Lake greenfield expansion project is expected to benefit greatly from the implementation of SAP technology. Because of the extensive SAGD infrastructure requirements associated with greenfield expansion projects, break-even prices in excess of $70/bbl WTI were needed to justify expansion. Consequently, Narrows Lake was placed on the back burner. But now, the project is leading the charge for expansion projects and holds the potential for the best economics among the company’s bitumen resources. Now that SAP is a viable option, we expect Narrows Lake to justify sanctioning at $45/bbl WTI. Accordingly, Cenovus announced that Narrows Lake will be the first of its SAP expansion projects.

Decades of Resource Potential, Best-in-Class Project Economics The recent purchase of the remaining interest in the Foster Creek Christina Lake partnership affords Cenovus with nearly 7.5 billion in proved and probable bitumen reserves. The vast resource base supports decades of production and provides plenty of opportunities to showcase the company's SAP technology. Based on its approved expansion phases, we expect Cenovus to add 330 thousand barrels a day of incremental bitumen production using SAP technology over the next decade. Once the expected expansion projects are completed, over half the company's bitumen will be produced using SAP technology.

Further increasing SAP’s attractiveness to Cenovus is its cost structure relative to peers. We expect SAP break-even prices, which include a 10% internal rate of return, to approximate $45/bbl WTI on the firm’s Narrows Lake and Christina Lake expansion projects. These SAP projects are among the cream of the crop of bitumen expansion projects, evidenced by project break-evens that are expected to be well ahead of peers. Furthermore, Foster Creek expansion projects will provide Cenovus with opportunities to generate free cash flow in our midcycle price environment. In addition to the favorable cost structure, we expect Cenovus to undertake the most SA SAGD growth in the oil sands industry. Our forecast of 330 mbbl/d of incremental production stands well above the peer group. As such, Cenovus appears to be in the best position to bring on low-cost production with its top-tier cost structure and vast resource potential.

Interim Growth Should Generate Value for Shareholders In the meantime, Cenovus intends to generate value with its near-term growth projects, beginning with the next phases of Foster Creek and Christina Lake expansion projects. Even though the full-cycle economics don't make sense in a $55/bbl environment using current extraction technology, a large portion of the projects' required capital was spent before the downturn in commodity prices. Consequently, when considering the remaining capital requirements, we expect the company to bring on 80 mbbl/d of incremental production that can generate free cash flow and bolster returns in the current environment.

In addition, Cenovus intends to supplement its bitumen portfolio with drilling opportunities in the light and medium conventional oil play Palliser Block. While not core to Cenovus’ operations, Palliser Block should not be overlooked as it adds low-cost production that will add incremental cash flow to the company. The company holds over 700 drilling locations in this play that can support up to 10 years of drilling. The production is weighted approximately 80% crude oil and boasts break-even prices that approximate $35/bbl WTI, including a 15% IRR. The company expects to begin drilling later this year, with conventional production growth expected in 2018 and beyond.

Low growth in the medium term will leave Cenovus with a strong financial position. Bitumen growth projects, coupled with Palliser Block drilling opportunities, will add incremental cash flow without compromising the balance sheet. Although Cenovus is one of the few oil sands producers expected to aggressively deploy capital on growth projects over the next decade, we still expect it to generate free cash flow amid all the spending. While the recent Foster Creek Christina Lake acquisition will temporarily inflate leverage, the balance sheet still looks strong, and we expect elevated leverage levels to be temporary. We expect the company to reach and remain in a net cash position over the forecast period while meeting all of its financial obligations.

Cenovus' Economic Moat Is Trending Positive Cenovus won't benefit from the cost advantage associated with its SAP technology by the time we reach our midcycle oil price forecast, which precludes us from awarding the company an economic moat. However, we believe the company will develop a cost advantage through the implementation of its SAP technology on its future bitumen growth projects. With project break-evens among the lowest in the oil sands industry, Cenovus' future cost structure is expected to compare favorably with peers. By adding a projected 330 mbbl/d of incremental bitumen production, the low-cost structure associated with SAP will significantly lower the company's corporate cost structure and bolster the return profile. As such, we award the company a positive moat trend rating.

Attractive Investment Opportunity With its 4-star rating, Cenovus is our best pick among the Canadian integrated stocks we cover. The stock is currently trading more than 40% below our fair value estimate, while on average the industry looks fairly valued. We believe the market is overlooking the immense growth potential in the company's oil sands reserves that can be brought on line with industry-leading, low-cost SAP technology in addition to the benefit from low-cost Palliser Block production. Furthermore, we think the market is underestimating the application of SAP technology to the company's recent Foster Creek Christina Lake acquisition, which will provide Cenovus with ample opportunities to bring on low-cost bitumen production. Growth projects that once faced challenged economics are now positioned to add significant value to shareholders over the long term. Consequently, we believe the stock presents an attractive opportunity for long-term investors.