Husky Energy Has Been Planning For Leaner Times

| About: Husky Energy (HUSKF)
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The long-term debt to cash flow ratio is projected to be a little more than two-to-one.

The company will emphasize its heavy oil projects.

The company uses its refineries to upgrade its heavy oil crude to higher-end products. It realizes extra profits for doing this.

The company has low capital sustaining projects to get it through the current downturn in satisfactory fashion. It plans to increase the percentage of low capital projects in the future.

Even though there was no cash on the balance sheet, the company plans to live within its cash flow, whatever that amount is next year. It will not borrow more.

Husky Energy (OTCPK:HUSKF) management stated that about five years ago, they took a good look and decided to formally plan for leaner times. But management had an additional take as to what that meant and below is one of the results.

"By the end of 2016, more than 40% of our total production will come from low sustaining capital projects compared to just 8% in 2010."

One of the qualms that many investors have with unconventional projects is the amount of capital needed to sustain production in the current downturn. This company has been planning for that contingency by highlighting projects that do not need much capital to maintain production in the current downturn. While the current year did show some production decrease, the company has several low-cost projects coming online this year (and maybe next year depending upon how things do) that will either minimize the decrease in production or perhaps even raise production in the downturn.

While production decreased a little more than two percent from the level of last year's third quarter, production is actually down more than seven percent when compared to the production levels of the fourth quarter for 2014. Management's answer to this appears to be to focus on their heavy oil projects, where they have decent netbacks and need minimal amounts of capital to maintain production and then increase refinery capacity as needed to manufacture more high-end products.

Source: Husky Energy October 2015 Corporate Presentation

From the slide above, only the White Rose Extension would be regarded as conventional. The other projects are unconventional oil projects. Once they are up and running, the various heavy oil projects require minimal capital investment for production maintenance. It is a very different situation that this company has the ability to take to survive the current downturn.

Source: Husky Energy 2016 Guidance Presentation, December 9, 2015

From the above slide, the company has a much more pessimistic view of the future of oil and gas prices. Therefore, it wants to be able to make money at WTI $40 and will only look at new proposals that are profitable at WTI $30. However, the company has been lowering its costs and has announced plans to lower its costs more this year.

Management is very cautious about using the futures market to plan future pricing and is very aware of the potential instability of OPEC when it comes to maintaining production. Management does believe that lower pricing is here to stay for a while, possibly even through the end of 2017, and is fully prepared to cut costs until the company is profitable in this new lower commodity price environment.

Source: Husky energy 2016 Guidance Presentation, December 9, 2015

From the above slides, the company has lowered the capital spending approximately $2 billion this year, although it intends to hold capital spending even with the level that it is at currently for the 2016 fiscal year. The company has stated, however, that it does not intend to incur any more debt because management is not comfortable increasing the debt level at this time. However, there is currently not a lot of cash on the balance sheet (in fact, none at all in the third quarter), so should commodity prices drop, there could be some decisions made about how to fit the capital budget into the reduced cash flow.

The company has projected significant cost savings for this year which continues a trend of lowering costs significantly every year for the last five years. The company expects to try to continue to extend the trend for next year, however, it has not yet guided on specific area savings.

The company had C$6.8 billion ($4.67 billion US) in long-term debt, approximately two-thirds of that is US denominated (and converted for reporting purposes) and the company reports it as hedges against its US investments for accounting purposes. Really, what the company is stating is that its US dollar debt will hopefully be paid by its US dollar earnings no matter what the comprehensive accounting reports in the current period. The company also has a credit line of nearly C$3 billion ($2.06 billion US) should it decide it needs to borrow money. It also has about $600 million in debt maturing over the next two years. Lately, the company has been paying the debt as it matures, however, should commodity prices go lower, the company has the option of using its credit line to pay the debt that matures. So liquidity for the next few years is not an issue for this company.

The break-even price includes exploration and development costs. Since depreciation, depletion and amortization reflect historical costs, the company could report enough non-cash charges to report a loss for some time until enough of the new more profitable projects replace the older costs and the older costs are sufficiently depreciated.

On an operating basis, for the third quarter, the company reported operating costs of C$15.52 BOE, royalties of C$2.70 BOE, transportation costs of C$0.51 BOE, and G&A costs of C$2.43 BOE. The total cash costs are $21.16 BOE before the non-cash charges (depreciation, depletion and amortization as well as impairment charges). So even with current commodity prices, this company has some decent cash flow. Plus, the Asian production is sold under fixed contract at more than C$15/MCF and so this price won't be affected by the current low gas pricing in North America.

So the challenge is to lower the finding and development costs to the point where the company makes money in the current low commodity pricing environment. And from the slides above, the company is making darned good progress on that and as a result, will probably achieve that goal. Plus, the refineries will help profitability quite a bit and take the risk away from the WTI fluctuations.

However, in a worst-case scenario, the company could hunker down and do the basic maintenance to maintain whatever production it could and use the cash flow that results to pay down debt, should it choose to do so. Many of its unconventional projects have long lives with low decline rates, so not expanding is nowhere near the threat to this company that it might be to a company doing the shale oil plays, for example. Husky is predicting enough money to fund a $3 billion capital budget, so even if the money came in at $2 billion after essential expenditures, it could pay off its debt in a little more than three years and have 12 more years (on average) left of cash flow for the new projects, and less for the older projects.

Note though that there is something of a current panic in the stock market, and there is always the possibility that oil and gas pricing could sink below the ability of the company to make money (even with the refining margins). Should a situation such as that persist for more than a year, it could seriously impair the prospects of the company. This company does refine its heavy oil into high-end salable products, and it does have some hedging, but it is not diversified enough to fully escape the effects of a long-term decrease in commodity prices should that happen. There is always the small possibility that refining margins and commodity prices could shrink at the same time, but currently, that is a remote possibility. Right now, the company diversification is doing what it should with the refining to high-end products and sales to the consumer market, substantially offsetting the commodity price declines.

Source: Husky energy 2016 Guidance Presentation, December 9, 2015

From the above slides, the profit picture for the heavy oil is fairly bright, thanks to the ability of the refineries to turn that oil into high-end products. Now as long as the margin stays as projected above, then the cash flow could be fairly steady, but should margins contract so that the finished prices do not meet that yellow line above, then cash flow could suffer quite a bit. Plus, two of the refineries will have major turnarounds next year. Those kind of projects carry more risk of delay and cost overruns than the usual minor maintenance projects.


The company has done its best to insulate itself from some of the more common industry risk. The refinery division, in particular, moves the risk from the crude oil price fluctuations to finished price fluctuations, which are more stable, but still carry some price change risk.

Source: Husky energy 2016 Guidance Presentation, December 9, 2015

From the above slide, the company has reduced and continues to reduce production maintenance costs. It has options to lower costs that many unconventional companies do not, plus it planned to maximize those options starting several years ago.

Management, however, waited for the current industry downturn to clear the decks of unacceptable projects. That action is better late than never, however, had management made the decision on those projects promptly over the last several years, disposition of those projects could well have been far more profitable to shareholders. Management stated that back in 2010, they were preparing for this downturn. Had they done a more complete job, then the giant impairment writedown would have been less, and maybe some of those properties could have been disposed of at break-even or better. That impairment charge is a black eye for a management that has made many good decisions to get this company ready for the current industry downturn.

There is a risk that the current stock market panic could turn into a full-blown downturn (and in a full-blown downturn, liquidity may be an issue and the company could lose a fair amount of money). But right now that does not appear to be the case. Now it looks like the economy hit a soft spot, but nothing like the downturn back around 2008 (although the risk of another downturn like that is always there to some extent). Refining margins could contract, finished product prices could decrease, and then the WTI prices could stay very low for an extended period of time and badly hurt this company.

But right now, that does not appear to be the case. Management has looked forward and believes that commodity prices will remain low for at least the next year and has therefore come up with a plan to survive and eventually thrive in such an environment. As such management is forecasting enough cash flow in the current environment to support a $3 billion capital budget for next year. The company has the credit lines and credit rating (BBB) to be able to get the cash needed to spend that money, or it can lower the capital budget if it feels that would be appropriate.

Long-term debt is roughly half of shareholders' equity, and the current cash flow is projected to be about half of long-term debt in 2016. That is a fairly comfortable figure with a lot of wiggle room should things not turn out as projected (or budgeted). The company does not appear to be in any kind of financial stress next year even if commodity prices decrease significantly from the projection (thanks to the refining division).

Plus, the company has another source of cash that it did not budget:

Source: Husky energy 2016 Guidance Presentation, December 9, 2015

From the above slide, the company appears ready to dispose of a significant amount of the above properties and their corresponding production. Supposedly, they have already engaged a financial advisor to help with the process. Depending upon what they sell and what they focus on, several of these properties could add a couple of hundred million dollars to the available cash for 2016 (and some are small enough to not be meaningful). Of course, some of the properties will be kept.

Source: Husky energy 2016 Guidance Presentation, December 9, 2015

From the above slide, the company has some very low-cost projects (that are profitable) available, and this is some of them. The presentation has many more. Enough of these projects allow the company to navigate the current low commodity pricing environment successfully. It also has the operating history to lend credence to that claim.

The company has a current market cap for the common stock (as of the close of the market on January 16, 2015) of nearly C$13 billion, preferred stock of roughly $1 billion, and long-term debt of C$7 billion. With projected cash flow of at least $3 billion for 2016, the investor would be paying less than seven times the total of the debt plus the value of the stock divided by the projected cash flow. That is a slightly depressed ratio for a company with this kind of profitability (and diversification) and an investment grade rating. Part of the reason for the low valuation may be due to the perception that heavy oil is not a premium product, but it can be very profitable for the companies that specialize in heavy oil and this is a case in point. Plus, the company changes its low-grade crude into higher-end products, which will enhance the ability of the company to navigate the current downturn.

Assuming that management has a fairly accurate and depressed cash flow estimate, then an investor can assume that management will grow that cash flow at least 10% per year. When oil prices recover, that recovery will increase the rate of growth, so this stock will be rewarding to investors at the current pricing. In a five-year time frame, oil prices will probably double (into the $50 range), which could easily increase the cash flow growth rate to at least 20% before any expansion in capacity is calculated in. The company plans on cutting costs until it is profitable again, which will be easier with the diversification than it is for just an oil and gas company.

The company does benefit in some ways from the weaker Canadian dollar when compared to the US dollar. But those benefits are mitigated by the fact that some of its debt also is in US dollars. Translation effects are more apparent on the financial statements than they are in the day-to-day operating results of the company. The reason is much of the time, the prices that the company receives for its products is in US dollars, particularly for the products of the refineries located in the United States. A substantial amount of the US debt reported by the company is related to those refineries, so the actual effects on the company may vary significantly from the reported amounts, particularly the non-cash charges. Nonetheless, the relation of the Canadian dollar to the US dollar also factors into the investment risk of this company's stock.

The company recently converted paying the common stock dividends from cash to in-kind common shares to conserve cash. While the $0.30 dividend (per quarter) provides a greater than 10% yield at current prices, and the company has a strong record of paying its dividends, investors should not count on the maintenance of the dividend at this time. The company has higher priorities in the current industry environment than paying the dividend. Maintaining a strong balance sheet, having adequate liquidity, and maintaining production should all take precedence over maintaining the dividend. Probably the best way to view the current dividend is as an extra incentive to invest in the company for as long as it lasts. The financial strength of the company, and the low costs, as well as the integration, probably lead to the conclusion that the dividend will be reinstated sooner rather than later if it is discontinued. Right now, the company needs to make sure it gets through the bottom of the current industry cycle in good enough shape to take advantage of the coming recovery.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

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.

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