Husky Energy: Uncertainties Despite Strengthened Balance Sheet

| About: Husky Energy (HUSKF)

Summary

Husky has had great success in divesting non-core assets.

At the same time, it is trying to prepare for even sub-$40 WTI.

It is currently in a dispute with CNOOC over its Liwan gas project. The outcome may affect restoration of its dividend.

Husky has had a pipeline spill in Saskatchewan that could lead to significant damages.

Husky reports in CAD; unless otherwise indicated, prices are in that currency.

Unless they are in distressed financial circumstances, most oil and gas stocks should have a positive upside over the next two to three years, as supply slowly contracts and the current glut is gradually reduced. The major questions for energy investors concern their timeline for anticipated pricing increases and just which companies will do better in that rising price scenario. Despite the fact that it is a major integrated company with diversified production sources, Husky Energy (OTCPK:HUSKF) has not been much in favor. Recently, CIBC called Husky "cheap as chips."

Part of the disfavor is because it has cut its dividend; the fact that Husky is controlled by a single majority investor is also an adverse factor for some investors.

Husky has clearly done some things right. It has basically directed itself toward low sustaining capital, low decline, production that could survive even with WTI below $40. It has significant downstream operations. It has vigorously pursued gas production opportunities in Asia, where pricing is still considerably higher than in North America. To improve its balance sheet, it has divested significant assets, some on very favorable terms.

Recent Divestitures

Recent divestitures and their effect on capital efficiencies was the major focus of Husky's Q2 Earnings Report. The major divestiture was the sale of a 65% working interest in Husky's Lloydminster infrastructure which went for $1.7 billion in a transaction with two friendly third-parties, affiliates of Husky's majority owner. Husky will maintain a 35% working interest in the properties as well as the operatorship of them. This transaction (which closed on July 18) will enable Husky to put a large dent in its debt, which at June 30 stood at $6.3 billion and produced a ratio of some 2.8x debt to cash flow from operations. (Q2 MD & A) Husky's target is to reduce this to 1.5x.

Husky has also announced two other asset sales that have not yet closed, but the proceeds of which will also be directed to deleveraging its balance sheet. The first was a sale to Freehold Royalties of some of its royalty interests for $163 million (plus some of Freehold's royalty interests in the Lloydminster area). The second was a sale to Whitecap Resources for $595 million of some producing assets in southwest Saskatchewan. In total, Husky will have sold about 25,700 boe/d of western Canadian production (including the royalty interests) for about $1.2 billion. Apparently another 8,000 boe/d are still on the market and could produce additional proceeds. Apart from the impact to its balance sheet, Husky has emphasized that the sale of these assets have concentrated the company on plays that have greater capital efficiencies and lower sustaining capital requirements.

Husky's quarterly report noted that with these capital efficiencies in place it is on track to achieve its target of overall earnings breakeven at sub-$40 WTI by the end of 2016. Even with reduced production, it is still on track for current annual production to average between 315,000 and 345,000 boe/d "albeit at the lower end."

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Gas Compressors, Liwan Gas Project (Husky photo)

The Dispute with CNOOC

For several years Husky has been a joint venture (49%) partner in the Liwan/Liuhua gas field in the South China Sea with state-controlled CNOOC, the Chinese National Offshore Oil Corporation (NYSE:CEO), which has an effective monopoly on Chinese offshore oil and gas development. Husky has similar joint venture agreements with CNOOC for the existing Wenchang field (40%) and further Chinese offshore developments as well as for the joint development of the Madura Strait play off east Java, now under development. Negotiations between the two for the sale of gas from a further field, Lihua 29-1 (largely using existing infrastructure), are in progress.

At the Liwan project, Husky operates the deepwater segment and CNOOC the platform, the 260 km pipeline and the onshore terminal facilities. All the gas is sold to a CNOOC subsidiary. Husky's contract is for five-years from 2014 at US$11-13 Mcf gas pricing (fixed in local currency), for take-or-pay of Liwan's full production. Husky had been receiving about C$15 (US$11.87) for the Liwan gas.

First quarter production averaged 207 MMcf/d natural gas and 9050 boe/d liquids. For the first quarter, however, CNOOC paid Husky for only 150 MMcf/d of the gas production, although it has made full payment for the liquids. After an outage, CNOOC, as the pipeline operator, installed a lower capacity temporary pipeline, and has paid only for the gas actually transmitted, a step that Husky regards as a violation of the take-or-pay nature of its contract.

Facing lower Chinese market prices, CNOOC wants both a reduced commitment to output and a lower price. Husky has gone on record as wanting a "value neutral" renegotiation. Husky is on strong legal grounds, but poor negotiating terms, since it requires CNOOC's partnership to sell on the Chinese market. A similar dispute between CNOOC and Primeline Energy has gone to arbitration. (For further information on the dispute, see my recent article "Husky Energy's Dispute With CNOOC Creates Future Doubts".)

While its Liwan production still represents only a modest part of Husky's overall output, the revenues expected represented some of Husky's best netbacks. Moreover, the Chinese and Indonesian partnerships with CNOOC were perhaps the most attractive of Husky's growth opportunities. The dispute with CNOOC puts both current revenues and future growth potential in jeopardy.

There have been talks to resolve the dispute. The Q2 Earnings Report did not elaborate, but said simply "Husky's discussions with CNOOC and its affiliated entities to resolve an issue related to the Liwan Gas Project have progressed to a framework for resolution. Further updates will be provided as the details are finalized." In the quarterly conference call, CEO Asim Ghosh would only add "very soon."

Some have taken this on a very optimistic note, but given the relatively low current Chinese pricing, it is difficult to envisage a truly "value neutral" outcome for Husky. The possibilities there may be to trade current lower gas pricing for greater future upside, or to trade instead lower gas for higher liquids pricing. To break even in the current situation, Husky probably needs CNOOC to take perhaps 160MMcf/d of its gas production capacity at a price of at least C$7.50 (US$5.75), which of course is far lower than the previously agreed pricing. For any meaningful positive cash flow from the Liwan operations, a still higher price, perhaps in the vicinity of C$10 or more (US$7.67), would be needed.

Revisiting the Dividend

At 2015 year-end, Husky announced that it had completely eliminated its dividend, which had become a stock dividend to which the market had reacted very negatively. Since then, management had indicated that the balance sheet was a first priority, but that restoration of the dividend might be considered. While much balance sheet improvement has been accomplished by Husky's asset sales, restoration of the dividend in the still current low oil price situation may well be dependent on a very positive conclusion of the Liwan negotiations. Investors might look for any announcement of a beneficial conclusion for Husky to the current discussions as a preamble to the restoration of a modest dividend.

Pipeline Spill

The day before it reported earnings, Husky had a pipeline spill, which resulted in a loss of some 250 cubic meters (200,000 liters) of oil, some of which reached into the North Saskatchewan River, the source of drinking water for several Saskatchewan cities and towns. Although the conference call simply suggested that everything possible was being done to clean up the spill. Husky's response has not been well-received publicly.

In particular, there are indications that Husky did not notify authorities of the spill or respond to it until the day after which signs of it were noticed. Apparently, the spill occurred when Husky began to use a pipeline expansion; Husky has since shut it down. Husky has some insurance coverage for the spill. The extent for which it may be liable to potential damages or penalties is unknown, and obviously the further start-up of the pipeline in question will require investigation and approval.

Analyst Recommendations

The following is a table of the most recent (since June 1) analyst recommendations regarding Husky. The target prices quoted are for HSE on the Toronto Stock Exchange and are quoted in CAD. At close on July 29, HSE was $15.36 (HUSKF: US$11.57).

Date

Institution

Recommendation

Target Price

July 25

TD Securities

Buy

$21.00

July 25

Scotiabank

Sector Perform

$17.50

July 25

BMO Capital Markets

Sector Perform

$18.00

July 24

CIBC

Sector Performer

$19.00

June 28

Desjardins

Buy

$21.00

June 13

Morgan Stanley

$22.00

June 6

Raymond James

$18.00

June 2

RBC Capital

Outperform

$19.00

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Risks

The greatest risk to Husky, as with any energy company, would come from a further major decline in oil or international gas prices, or sustained pricing at current levels for a long period.

There is always a particular risk to a company like Husky from some major incident damaging its physical operations at an oil sands project like Sunrise or its offshore platforms that could greatly curtail its production or cause environmental damage.

As a major oil sands producer, Husky could be impacted by any further restrictions on GHG emissions, although the new Alberta provisions are probably beneficial to the company.

With a single major controlling shareholder, there is always the possibility that the interests of minority holders will not sufficiently be considered.

Given the international nature of Husky operations, which include projects in China, Indonesia and Taiwan, there is always a certain geopolitical risk.

There is a particular present risk to Husky from its current dispute with CNOOC in terms of the returns it will receive for Chinese offshore gas.

For U.S. investors there is a risk from any decline in the Canadian dollar. Given a Canadian economy that is weaker than the U.S., the CAD could decline still further. At the same time, the current slide in the CAD is largely attributable to the economic damage from low oil prices; an increase in crude pricing would almost certainly strengthen the currency.

Investment Thesis

Husky has made major efforts to repair its balance sheet and to prepare itself to lower for longer crude pricing, even at the high $30 level, by an emphasis on low-sustaining capital operations. It may be currently under-appreciated.

Husky's current divestitures, on advantageous terms, should go far to improving its balance sheet position, without greatly impairing future growth possibilities.

Its fixed-price, take-or-pay, Asian gas prices with their consequent high netbacks, are, however, what made it particularly attractive as an investment with an untypical area of secure growth potential. Its firm contracts with CNOOC were regarded as a major strength. The current dispute throws that relationship into doubt, both financially and otherwise. Investors should take a close look at the outcome.

Right now, energy investing offers numerous types of opportunities. Potential Husky investors must first decide whether they value the company's diversification, or whether they might wish to invest in another company with a more particular focus.

In the short-term, Husky has been made more defensive by its downstream operations, which profit from low crude pricing. With refining margins generally trending lower, however, the integrated companies may be losing their advantage.

DISCLAIMER: The information provided above is not a recommendation to buy or sell a stock. It intends to increase investor awareness and to assist investors in making smarter decisions. Prospective investors should always do their own further research, and take into account their own current financial holdings, their risk levels and their shorter or longer-term outlooks.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.