Cenovus Energy: Financial Reasons For Merger (NYSE:CVE)

Summary

The merger gives management a lot of work to do fast.
Husky thermal cost ran high.
Cenovus needed refining capacity.
For the two above reasons, the combined company should be more profitable.
The conventional business will take a seat to more important priorities.
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Any large merger can have daunting logistics. For this reason, some have their doubts about the recent Cenovus Energy (NYSE:CVE) merger with Husky (OTCPK:HUSKF). However, there had to be compelling reasons to even attempt a merger of this scale. Now that the annual results are out for Cenovus Energy, some of the reasons look obvious.

Cost Reasons

Cenovus has some of the best thermal costs in the industry.

Source: Cenovus Energy Fourth Quarter 2020, Earnings Supplemental Materials

As shown above, the heavy oil operating costs are extremely low. This meant that the Cenovus refining partnership was getting some very low cost materials to upgrade. Even though the upgrading and refining process adds value to the finished product, the incoming cost still matters to overall company profitability.

Cenovus management estimated many times that the refining capability of the partnership would cover about 25% of the production for Cenovus as a standalone company. A whole lot more product should be upgraded by the combined company after the merger (as opposed to selling the product to another refinery to upgrade or refine).

Source: Cenovus Energy 2021 Budget Slide Presentation January 2021.

This slide shows the additional properties that are now included with the combined company. All of those additional properties in this new slide is high cost. Long term, the combined company will either reduce operating costs sharply or shut down these properties because Cenovus has access to plenty of low cost production.

Husky clearly made money by upgrading the material processed in the refineries owned. Husky would have struggled as an upstream producer selling thermal products on the market. Husky refineries now have access to the lower cost Christina Lake And Foster Creek production.

The cost savings of using lower cost material may not happen "overnight." Husky had far more refining capacity than it had production. Therefore Cenovus really acquired a refiner with some upstream production.

So the first order of business will be for the combined company to use more and more of the Cenovus product. Later as that integration process is accomplished, the combined company can decide if costs on the high cost production can be brought down enough to continue operations or if those higher cost raw material sources need to shut down.

Multiple Profit Points

The combined company will now be able to make money from the products produced at more than one point. This part seems to have been lost in many discussions that I have reviewed. Cenovus Energy as a standalone company sold most of its upstream production on the market. Similarly, Husky as a standalone company, purchased a lot of products on the market.

Source: Cenovus Energy 2021 Budget Slide Presentation January 2021. Compare this slide to the one before it and it's clear that the combined company upstream production clearly comes reasonably close to the capacity of the refining system. There will be some more refining capacity on the way once the Superior Refinery is rebuilt. Just as clearly, management can adjust production volumes to more closely match refining capacity by shutting down the high cost production.

More importantly, once the operations optimization is complete, this company will make money both at the upstream level and at the refining level. Two profits provide much better insulation to the gyrations of the commodity marketplace. Now profits will depend much more upon the price of the refined products. Those prices will likely be a little more resilient to some of the larger commodity price gyrations. Only a total collapse would cause this type of integration to fail (as happened in the second quarter of 2020).

The Conventional Businesses

There are two parts to the conventional business. The first part is:

Source: Cenovus Energy 2021 Budget Slide Presentation January 2021.

This part of the business is likely to remain in "cash generation" mode with production remaining either stable or in a slight decline. Clearly, the main part of the business needs to be dealt with before this part of the business becomes important.

There are a lot of good possibilities here. But the merger details have to come first as they are likely to be far more significant.

The other part of the conventional business may prove to be more significant first. I wrote how Cenovus Energy management previously gave the conventional discovery on their thermal lands to Headwater Exploration (OTC:CDDRF) to develop. Because this is being developed by a separate company with management experience in conventional type parts of the industry, this development will proceed in the current year. If this works, then management may use this model to try to develop more conventional parts of the leasehold areas that are undeveloped at the current time by using this model.

Management needs the conventional business for further diversification. The heavy oil needs to be mixed with condensate in order to flow through the pipelines. Condensate in Canada is relatively expensive as a fair amount gets imported. Therefore, the light oil business has the potential to cut costs is yet another place for the newly diversified combined company.

Conclusion

Management definitely has a full plate after a merger of this size. The thermal business has to be whipped into shape as well as the refining. Once all of that is optimized (and that could take a while) then there's the conventional business.

Management may want to wait to see how the venture with Headwater works out first. If that does work well, then the other conventional acreage could well be a candidate for a similar arrangement.

The time involved for all this could easily be two years. There are many things not discussed like accounting systems that need to be combined. More than one management has thrown various administrative systems together with less than desirable effects. Things need to be done correctly and completely in order for shareholders to properly benefit from this merger.

In the meantime, the quarterly reports should clean up quickly. Probably within six months, the number of one-time entries should be decreasing rapidly. It may take considerably longer to optimize operations. But the results should be transparent.

Cenovus Energy has needed more refining capacity for some time. Management has now found that capacity. So profitability should increase to be more than the two companies on a standalone basis. That possibility would imply a fair amount of stock price appreciation from the current price.

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This article was written by

Long Player

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Long Player believes oil and gas is a boom-bust, cyclical industry. It takes patience, and it certainly helps to have experience. He has been focusing on this industry for years. He is a retired CPA, and holds an MBA and MA.

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