By Mark Bern
In December 2009, EnCana (ECA) spun off its integrated oil and liquid natural gas operations forming Cenovus (CVE). The idea at the time was that splitting the two companies into separate entities would unlock value for shareholders as the market would provide better recognition of the assets. Well, so much for that assumption. Since the split, EnCana’s stock price has fallen from about $60 per share to $18.27 while the price for a share of Cenovus has risen from about $25.50 to close at $ 33.75 on January 11, 2012. I believe the spinoff resulted in each shareholder owning 1 share of each company, so today that original $60 would be worth about $51.02, plus accumulated dividends of about $3.60, for a total of $54.62. An investor would seemingly have been better off in a money market account paying .01%.
That’s the past but our job, as investors, is to look into the future, thankfully. And there are really two parts of the future we need to look at for each company: short-term and long-term. Since I don’t claim to be very good at timing the markets I tend to place an emphasis on the long-term, but in this case the short-term is very important.
EnCana pays a nice dividend yielding 4.3%, but there is some risk as to whether the company can maintain the dividend level as earnings per share for 2011 are likely to drop below the declared $0.80 per year dividend level now in place. Also, the company’s cash position has dropped by half from the end of 2010 to the end of September 2011 to $310 million. The current dividend level requires cash payout of nearly $150 million per quarter. The company has agreed to sell some assets in North Texas and British Columbia bringing the total of assets sales for the 2011 fiscal year to approximately $2 billion and both deals were scheduled to close during 2011. Cash flow for 2011 was expected to total around $3.8 billion but capital spending in 2012 is expected to be about $4.4 billion. The two asset sales should total $1.175 billion, so it is possible that the company could maintain the dividend if natural gas prices rebound a bit. But that is the crux of the problem: natural gas prices.
Currently, the natural gas supply is getting ahead of demand as the shale gas drilling opens up huge new reserves. According to the Energy Information Administration, U.S. natural gas storage levels are well above the high end of the 5-year historic levels. Unless this winter turns unseasonably cold, natural gas prices are more likely to drift lower that go up. That is not good news for EnCana shareholders for the short term. And it may lead to a temporary reduction in the dividend which would likely lead to a lower stock price. So, the short-term for EnCana does not look so hot.
The long-term potential is much better for EnCana than the short term. I wouldn’t recommend buying the stock today, but would probably wait until mid-summer of 2012 to watch the dividend situation. If the dividend is cut, I would expect the stock price to drop further and provide a good entry point for those investors with a long time horizon. I believe that natural gas, due to its abundance, will be used for more electricity production and transportation applications in the not-so-distant future (3-5 years) and that the added demand will help support prices of 50% or higher from current depressed levels. Also, the production supply levels will eventually level off allowing demand to catch up; another reason to expect natural gas prices to rise at some point. That being the case, I believe that there is above average long-term price appreciation potential and support for eventual dividend increases to make this stock a good investment; just not yet. I don’t think that the bottom is quite in so I’m going to recommend waiting for the real bargain yet to come.
The dividend for Cenovus is not so generous, but it is more likely to rise with regularity over the foreseeable future. The short-term outlook for the company is similar to its recent history which is about as good as it gets in the oil business. Over the last five years Cenovus has been able to increase production at its oil sands properties by an annual compounded growth rate of approximately 29%. Production on those properties is expected to continue to grow at a compound annual rate of 20% going forward. Overall, the company has expanded production by 14% compounded annually and expects to do that or better going forward as the emphasis on developing its oil sands properties becomes more the focus.
The company has adequate cash flow to cover capital programs, debt service and dividends. The debt to capital ratio is a manageable 30%. Thus, the company has adequate capital resource flexibility to fund its aggressive expansion plans, both in the short and long terms.
The major risk is again the market pricing of its products. But even with the global economy growing at a continued slower pace (relative to 2007 and prior) the price of oil has been supported by supply constraints and likely will remain above the very profitable level of $85 per barrel. In fact, as economies around the globe recover, the pace of economic growth is likely to increase placing further pressure on oil prices in the future, especially long term. With average operating costs of under $15 per barrel, investors can see the potential cash flow and profitability the company possesses.
Short term, I would say the prospects for Cenovus share appreciation is good, but the dividend will probably not keep up with the share growth meaning that the yield will remain subpar. Long term, I expect that cash flows will, at some point, exceed capital requirements by enough to provide greater flexibility in the dividend policy (i.e., larger increases) and make share buybacks more possible. Both of these future efforts, if they become reality, would provide additional impetus for share appreciation. So, the long-term potential may be even better than the short term, in my humble opinion. Therefore, I believe that Cenovus is a stock investors should buy and plan to hold for at least the next decade.
I don’t own Cenovus or EnCana. But I am planning on purchasing Cenovus for my core portfolio within the next few months. Here is my plan. I will sell put options on Cenovus with a strike price of $35 and expiration date of June 2012. The current premium is $4.10 (bid), $4.40 (ask) as of the close of the market on January 11, 2012. Assuming that I get $4.10 if I sell tomorrow, one of two things will happen. In either case I get to keep the $4.10 per share from selling the puts for tying up my cash for a little over five months. That amounts to a return (after commissions) of 11.88%.
Assuming I don’t get put the stock, I’ll do it again in the second half of the year so I’ll probably be able to double the cash premium received for an annual return of 23.78%. So, if I don’t get the stock, I make almost 24% on my money. That was the first of the two outcomes.
The second thing that could happen is that I get put the stock between now and June if the price of the stock remains below $35 a share (very possible), in which case I am obligated to buy the stock at $35 a share. But, taking the premium collected into account (required for tax purposes) I will have a cost basis of $30.90. That means I get the stock at a discount of 8.4% to the current price and will have increased the dividend yield on my cost to 2.5% from the current 2.3%. Either way I’m happy!
For readers who are interested in the detailed mechanics of how to sell put and call options to enhance their portfolio income please consider reading some of my series of article on that subject. For your convenience I have created a listing of links to all of the articles in that series through this one link.
For readers who are more interested in companies that pay a rising dividend I have created a similar link to a list of articles I have written on that subject here.