Description

Cenovus Warrants (CVE.WT-T)

Before you read further, warning – the same author previously wrote up Obsidian Energy 3 years ago.

With that out of the way, I believe the Cenovus 5 year warrants expiring January 2026 appear mispriced and can be used to generate a compelling risk/reward profile. Specifically, I recommend buying the CVE warrants for $4.91 and writing Jan 2023 $11 calls to collect ~$2.25 – as a way of only paying for the intrinsic value of the warrant by capping the upside for 2 years.

My investment thesis is:

1) The warrants are mispriced because they were issued with the Cenovus/Husky merger as a sweetener but many larger Husky shareholders were the passive/index type who probably don’t want to hold the warrants. This may be part of the reason the implied volatility in the warrants are lower than the call options on CVE.

2) The market appears to heavily discount the deal synergies. Especially on the cost side, given Husky’s previous G&A levels and employee count, at least a good portion of the synergies appear reasonable.

3) With longer-life E&P assets and currently challenging refinery environment, there is a reasonable probability cashflow improves sufficiently over the next 5 years for the warrants to work.

Brief Background of the Husky and Cenovus

Cenovus (CVE): Formed in 2009, Encana created Cenovus to hold the oilsands assets while Encana itself focused on natural gas. Generally smaller in size than CNQ, Suncor and Imperial, CVE’s desire to grow its oil asset production base had to come in the form of buying out ConocoPhillips’s 50% stake in the Foster Creek Christina Lake asset, and, now, Husky.

Husky (HSE): With Hong Kong billionaire Li Ka-shing acquiring a stake in Huskey in the late 1980s, HSE grew into a hodgepodge of assets including downstream refineries in the US, upstream oil assets in Western Canada and Asian offshore gas production. With a confusing mix of assets and mediocre historical results, Li Ka-shing put in Asim Ghosh as Husky’s CEO in 2010. Supposedly, given his background in telecommunications, he was to bring in an outsider’s perspective and improve capital allocation and discipline for Husky. With mixed results and a 2015-2016 oil downturn, Asim stepped down and Husky resumed its acquisition spree, buying the Superior refinery in 2017 and attempted to buy MEG energy in 2019.

Ultimately dropping its MEG energy bid, it appears HSE would lose its credibility as an acquirer going forward which may have led to the HSE/CVE merger.

Cenovus/Husky Merger

With the state of the energy industry, particularly in Western Canada, it is not that surprising we continue to see consolidation between players. From going through the November 2020 information circular, I found the following to be quite interesting:

1) It appears Li Ka-shing was initiating and driving the process through a Husky board member to advance discussions with Cenovus. Perhaps, Li Ka-shing, finally would like to see value unlocked with a transaction and have enough confidence to allow for an 18 month standstill agreement

2) The transaction had Husky shareholders get 0.7845 CVE shares and 0.0651 CVE warrants (expiring Jan 2026). Interestingly, it doesn’t seem like the warrants are subject to standstill for Li Ka-shing. Also, with that ratio, it seems shareholders would more likely not particularly care for them and dump that when given the chance – especially HSE appears to be held largely by passive holders like Franklin Resources, Fidelity, Vanguard and Canadian banks.

3) The $1.2 bln in savings from sustaining capital ($600 mln) and corporate ($600 mln) appear fairly reasonable – especially on the corporate side, considering HSE’s G&A costs and employee count is very roughly 2x CVE’s.

Valuation – Normalized FCF

Because the focus of this write-up is on the warrants, my approach to valuation is to figure out what normalized FCF looks like for the new Cenovus. In other words, as long as we get to a normal year sometime in the next 5 years, one should be comfortable holding CVE warrants.

Although there appears sufficient cost disclosure from both Cenovus and Husky, I find the general references to “cash costs” and netbacks to be somewhat disingenuous. Instead, I looked both HSE and CVE upstream and downstream segment reporting – both of them reporting segment income (operating income which approximated segment EBIT). Interestingly, despite year to year variations, DD&A did not vary that significantly from capex on average.

Upstream – Here I assume stagnant production growth as Cenovus will hopefully be more disciplined in spending capital to grow the legacy HSE assets. My assumptions in a normal year are:

1) US$60 WTI

2) 720K boe/d production

3) All in costs in the mid C$50/boe

4) Normal EBIT of C$3 bln

Downstream – Here I assume some improvement in crude oil runs, refining throughput and static upgrading throughput. My assumptions in a normal year are:

1) 850K bbl/d processed

2) Downstream operating margin in the range of C$4/bbl (historically varied widely and currently very low/negative)

3) Normal EBIT of C$1.2 bln

Taking an average $0.7 bln corporate segment loss, we get to a normal EBIT of ~$3.5 bln. From there, I assume $250 mln/year in operating and corporate synergies and $200 mln in capex synergies (compared to CVE’s estimate of $1.2 bln in annual synergies). In particular, it would seem the operating/corporate synergies are conservative and make sense as CVE had about 2,300 employees while the smaller HSE had 4,600 employees. Reducing the workforce in the range of 2,500 staff would assuming C$100,000 all in cost per staff would already yield $250 mln in annual savings. Adjusting for some CVE G&A not captured in their segment reporting and interest expenses, I get a normal Profit Before Tax number of just over C$3 bln and an aftertax profit/FCF estimate of $2.3 bln.

Using a 10x multiple, I get a CVE value in the C$11.50 range.

Running CVE at US$50 oil gets be around C$5 per share, while US$70 oil gets me C$22 per share. As there isn’t a lot of precision around this, the point is CVE is very sensitive to commodity price assumptions – which make long-dated warrants particularly suited for this situation. As a bonus, the CVE warrants trade at an implied vol of 50% while 1-2 year out CVE call options trade at an implied vol of ~55%.

Buy CVE Warrant, Sell CVE Jan 2023 C$11 strike Calls

With a view that CVE should be worth in the C$11 per share range, I think the best way to capture the warrant pricing inefficiency is to buy the CVE warrants for $4.91 (strike C$6.54, expiring Jan 1, 2026) and selling Jan 2023 C$11 strike CVE calls for ~$2.25.

Features of this trade:

1) By writing call options, the proceeds cover most of the implied time value of the CVE warrants beyond the intrinsic value (being $9.51-$6.54 = $2.97). The net outlay is ~ $2.66 per share.

2) If by expiry, CVE > $11, we stand to capture $11 - $6.54 = $4.46, a gross return of 68% or likely ~30%+ IRR

3) Although this trade theoretically starts losing money at CVE < $9.2 per share ($6.54+$2.66) In January 2023, the warrants still provide a cheap look at future upside as the expensive time value of the warrant has been mostly offset by initially writing long dated calls upfront. Further, in January 2023, so long as CVE < $11, I would consider writing another long dated call 2 years out to potentially lower the breakeven price from $9.2 to the $7 range (assuming the calls will still be priced similar). Granted, there are many variables and the results are path dependent – the basic point is even if the CVE share price doesn’t go higher and reach our intrinsic value estimate, one could rewrite long dated calls in two years that could potentially bring the cost base of the warrant cost to ~$1 (if we are wrong on CVE but able to collect $2+ in premium to write 2 year call options, twice), minimizing the magnitude of capital impairment in the event I’m wrong

Disclaimer: Not investment advice, do your own work. Author may take, change position anytime without disclosing. Subject to errors.

Catalyst

Clarity from upcoming AGM

Higher Oil Prices

Rationalization of assets, cost synergies realization