Cenovus Energy Inc. (CVE) Earnings Call Transcript & Summary

All right. Good afternoon. Welcome back, everyone, for the next session here. I'm Phil Gresh, North American integrated oils and refining analyst here at JPMorgan. For this 30-minute fireside chat, I'm pleased to have Jon McKenzie, EVP and Chief Financial Officer of Cenovus Energy. Jon, always great to speak with you. Looking forward to digging into a number of topics on Cenovus and Canadian energy. I thought maybe I'd give you an opportunity here for a couple of minutes, first, just to give an introduction with some of your high-level thoughts. Always great to get your thoughts here. So why don't you kick it off, and we'll go from there.

Great. And thank you, Phil, and thank you for having us at your conference. Thank you to everybody joining virtually. This is a bit new for everybody, but it seems to be remarkably efficient. So we do appreciate you taking the time to listen and having an interest in our company. I'll make a few comments, and then we'll get straight to the Q&A. But just with regard to COVID-19, what I would say is the company has not had a recorded case of COVID-19 in our field operations nor in our head office here in Calgary or any of our satellite offices. So we have had a fairly light touch in Alberta, and we've been spared the worst of the brunt of this disease, and we're really in the process today of getting back to normal. So that is a good news story for us and a good news story for the company. What I would also tell you is as we went into this downturn, the company acted fairly quickly. And we were really focused, laser-focused, if you will, on 3 things. And when you get into these downturns, what I would say is the playbook doesn't change. You just don't know how deep and how long they're going to last. But this company has been focused on 3 things, as I mentioned. It has been focused on the balance sheet, it's been focused on our breakeven costs and it's been focused on maintaining and adding liquidity to the company. And we were fairly quick to move forward with some announced changes to our business plan back in March. I'll remind you that we shut in our rail program quite quickly. That was entirely an economic decision. We reduced our capital spend down to about CAD 800 million to CAD 850 million. We cut our operating costs or G&A costs as well as our dividend, and we believe those are all prudent measures to take in a world where we're below $45 WTI. The other thing that I would tell you is that the business model that we have put in place is flexible. And those kind of cuts that we've made really don't come with a lot of long-term consequences to the business or to the assets. We're able to manipulate those and have that kind of flexibility in our financial and operating model to react to situations like this. So even in our production, for example, back in the early part of this quarter, we had reduced production by about 60,000 barrels a day, which is much less than what we've done in the past. But we can do that fairly quickly. It's a fairly simple adjustment to the field without those kind of long-term consequences. What I would also tell you is we came into this with considerable liquidity. As a company, we maintain $1.6 billion of bilateral facilities. Those are uncommitted. $600 million of that is able to be drawn. $1 billion of that is related to our LC capacity. We have $4.5 billion committed capacity on our revolvers, and then we added to that another $1.1 billion of committed capacity through a revolver. So the company has plenty of liquidity to get through this downturn and manage through the balance sheet. What I would also say is that we have been really focused as a marketing group and as an operations group to bring those 2 together to make sure that we've made the right economic decisions in terms of production. We watch that every day, although we don't -- making sure the tap is on and off daily. We've been seeing some pretty strong price signals through the last few months telling us to produce, and that's what we've been doing. So anything that really adds or covers our variable cost [ nets ] and the fixed cost base of the company is really signal for us to produce, and that's what we've been doing through this time. So what I would suggest is that our priorities as a company haven't changed. As we come out of this, we will be a company that's focused on deleveraging, focusing on our costs, we're focusing on market access. But we feel like we're through the worst of this, and we're certainly in a position today where it's starting to get back to normal across a number of fronts. So with that, Phil, I'll turn it back to you, and then we can take any questions that you might want to explore more deeply.

That's great. That's actually a super helpful overview. So maybe we can just start with the operational side of things. So you mentioned 60,000 barrels a day of shut-ins at the trough. I guess it sounds like, at this point, would you say you're back to -- given the price signals, you're back all the way to a full run rate? Or how are you thinking about things, particularly as it relates to the transportation alternatives that are available to you for moving your barrels and the overarching kind of rules with takeaway in Canada right now?

Yes. So as you mentioned, Phil, we are still subject to curtailment, and our liquids production curtailment number is about 367,000 barrels a day. And back when we announced that we had reduced production by about 60,000 barrels a day, 30,000 of that was related to our rail program. So in Canada, we are able to overproduce above curtailments so long as those barrels leave on rail. And when we shut in our rail program, we had to reduce our production by about 30,000 barrels a day. And then with the economic climate and the pricing signals we saw back in April, May, we had reduced Christina Lake by about 30,000 barrels a day as well. What's changed and what's kind of remarkable since that point is the heavy oil and location differentials have really narrowed than what we've seen with the WCS-WTI differential as it settled in June at about $4.35, and that's about as narrow as I've ever seen it. So that, combined with discounts in condensate prices, are giving us a very strong signal that not only today are we covering our variable cost by producing more, we're actually covering our fixed cost as well and generating free cash flow. So even at these very low WTI prices, with the benefits that we see from narrowing of the differential and the widening of the condensate spreads, the economics today are actually quite robust.

Right. Interesting. So maybe just to step back and take a look at the exact same equation for the overall industry. Based on your analysis, where do you think industry shut-ins maxed out? And where do you think we are now? And how soon do you think the entire Canadian industry could get back to normal?

Well I think we're seeing 2 things, Phil, in the Canadian industry. We are seeing some shut-ins that are economic. And for those companies that have a higher cost structure but can't cover their variable costs, we have seen some shut-ins. But with the price signals that we saw in the spring as well, I think it incented a number of companies to take production off and go into an early turnaround season or a lengthened turnaround season as many kind of thought this was going to be the low point in the trough. So we would estimate that there's somewhere just north of 1 million barrels off-line today. It could be slightly more than that. We would think the vast majority of that comes back through time. There will be some casualties along the way. But I think the reality is if you look at the companies that have taken off the biggest number of barrels, we would expect through time, those barrels to come back once they're through the turnaround season and assuming that the economics of producing oil today remain on the positive side of variable cost.

So for the industry as a whole, as these barrels come back, the vast majority come back, and you think about the industry transportation situation, are we going to get back to needing crude by rail at some point in 2020 or 2021? I know there's been some debottlenecking of some pipelines as well in recent months. So where do you think that will shake out?

Well what I'd say is longer term, there's no doubt, we need more export, we need more egress in Line 3, TMX and XL in longer term. I mean, how this plays out through the fall of this year, I'm not sure. What I would tell you is that we would anticipate that the WCS-WTI differential will widen as we go through the summer months, so we'll start to see some of these [ buried ] barrels appear. And then in the winter months with the demand for heavy oil being at a seasonal low and condensate requirements increasing, I would expect those differentials to widen and the pipeline situation to tighten up. Now does it tighten up to support rail economics? We don't know. But what we have done is we've placed all of our cars in storage, but they can be very quickly taken out of storage and placed back into service if we took a view that through the winter months and through the longer part of the cycle, we were going to be in a world where the differentials were in the high teens or low 20s, which would support moving more barrels by rail. I think the other thing that I would say on this is what we have seen through this downturn is it's not just the pipelines and the location differentials that have tightened, but it's also the heavy oil spreads on the Gulf Coast which have tightened up as well. So even if we do start to see pipes filling and the location differentials start to widen, we think that the heavy oil spreads are going to remain robust not only through the foreseeable future, but we think long term, heavy oil is going to be in demand, and we're going to see a relatively tight spread between heavy and light oil.

So as you look at your own situation, if you were to continue to bring barrels back, if the differentials did not support crude by rail, but the underlying economics of producing the barrel are still positive, are you -- would you be willing to take a hit on transportation to produce the barrel? Or would you rather keep the barrel shut in?

No. What we look at, again, Phil, is we've got -- if we're going to be producing barrels, we've got to cover our variable cost, and that would include the variable cost of transportation. So to the point that we are covering off some of our fixed costs, you will see us produce. And that's just straight up good economics. Rail is a little bit different, in that rail is a longer-term commitment. It's not something you start up and shut down and think you have that kind of flexibility. You've got to take a longer-term view. It's a very high touch, high level of coordination method of transportation. And you really need to drive the cost out of the business over the long term. So one of the things that we -- when we got into this business is, as we said, we were going to run rail for 3 years, and we were going to get good at it. And that it was going to be an option for us if the pipes were continuing to be delayed or weren't coming that it was going to provide us incremental egress. So when it comes to rail, we take those kind of or that kind of thinking into our process before we ramp it up or down. But we're about a year into that. And with the downturn we saw, it just made sense to shut it down. But if we were to bring it back, it would be with a view that we're going to run it through the rest of that 3-year term.

Got it. Okay. Kind of moving back to the cost side of the equation. You've talked about reducing your breakeven. I think you had talked about a $38 free cash flow breakeven, I believe, on your last call, $38, I believe, in U.S. dollar terms. Now I believe that was also with the CapEx numbers you were talking about, which I also believe are below your sustaining capital levels this year. So maybe you can just talk about your ability to continue to drive that sustaining capital costs lower towards your level of spending today. In other words, can you actually bring that down further if it has no long-term consequence, as you mentioned? Or would you expect capital spending to have to go back up and, therefore, have an impact on your breakeven in future years?

Sure. So just to level set on the breakevens, what we talked about on our conference call was that the company breaks even at $38 WTI, and that was after we had made the capital cuts and the dividend cut and the operational cost cuts that we've talked about. But that's an all-in cash number, and that assumes a $13 crack with about a $12.5 differential in condensate trading and about $2 under WTI. On an operational basis, excluding capital, we break even at about $35. So in today's world with condensate being at about $4 under WTI and with the differential being on a spot basis close to $7, our breakevens are much lower than $38 for all-in cash and lower than $33 million on OpEx. When we think about the OpEx -- or sorry, the CapEx that we're investing in FCCL today, we would say that on a normalized basis, we need to spend between $4 and $5 per barrel, and that translates to a higher number than where we are today. So because of the flexibility that we have in the way that we manage our well pads and well pad construction, we were able to reduce our total CapEx this year to about CAD 800 million, CAD 850 million that I spoke to. That is not a long-term run rate. What we have said, and we continue to reiterate, the long-term sustaining capital for this business is somewhere in the neighborhood of $1 billion to $1.2 billion. And that would include about $800 million for our assets in Christina Lake and Foster Creek, $200 million for the refineries. And if we chose to keep production flat in the Deep Basin, we'd need about $200 million to do that. So those are good long-term run rate numbers. So when you think about where this company is using the metrics that I talked about in terms of the differentials, the long-term breakeven is probably closer to $39, $40 on a run rate basis.

And the $39 to $40, that's a cash flow breakeven or free cash?

That's free cash break.

Okay. Got it. You talked about preserving liquidity and protecting the balance sheet. Given the breakeven that you talked about, where do you see net debt levels then? What would that imply for where net debt would end this year? And maybe just talk about your $5 billion long-term target. Obviously, COVID is a bit of a step backwards there. But just talk about how you think about the timing or the potential of getting to that target ultimately would be. And also, I'm thinking, embedded in this net debt level, there's changes in working capital and other things that can -- and deferred taxes and other things that can swing things around quite wildly. So any help you could provide on that would be helpful.

Yes. Working capital will swing things around a little bit. And the way to think about our company is there's probably 20 million barrels that we have in inventory at any one time. 10 million of that would be in the downstream and 10 million of that in the upstream. And the upstream would be a combination of bitumen with bitumen condensate. And we think that's a pretty good run rate in terms of working capital requirements. What I would -- we finished Q1 with about $7.6 billion of net debt. And that's -- these are all Canadian dollar numbers, and then we signaled Q2 to expect that number to go up. One thing we have been pleasantly surprised with, which I spoke to a little bit earlier, is we reached free cash flow positive situation earlier than we would have thought back in April and May. And that's really, again, related to those differentials narrowing that I talked about, both on the WCS-WTI and then the widening of the condensate. So we're in a world today where we are producing free cash flow, and that free cash flow is going to debt reduction. One of the things that we have been very clear about since both Alex and I came to this company is that the balance sheet is an absolute priority. And what you can expect us to do coming out of this is continue to allocate the vast majority of our [ free cash flow to ] the balance sheet in pursuit of that $5 billion target. What I would also tell you, Phil, is that our thinking around that is only hardened by the events of the last 3 months. And the way you should be thinking about is $5 billion being more of a ceiling on our net debt than a floor. We constructed the company to be profitable, to generate free cash flow, to sustain the dividend, and we based all of our financial framework around returns to shareholders and capital allocation around a $45 WTI world. And we still believe that the hydrocarbon industry does not work well at $45 or prices below $45. We still think that's the right number. But what we've demonstrated is you can have these periods where you go significantly below $45. This is the third time in the last 15 years, and this looks to be the sort of the deepest and the longest. But understanding that we need to make sure that we've taken good care of the balance sheets, so when we have these kind of issues, we come out of them in a relatively good shape.

Sure. It's interesting, you had your Analyst Day last October, and obviously, a lot has changed. So if you were to kind of recalibrate to that -- to the reality of today's world, what, if anything, would be different in terms of how you laid that out? Obviously, you wanted to get to the $5 billion target anyway before really pursuing any growth projects. That was pretty clear at the time. But it sounds like you said, your conviction in doing this has since hardened. So it seems like you will be on that path, but does it change your opinion on growth from here or anything else that you had laid out at the time?

No, I don't think it does, Phil. I think we've been really clear that there is no growth until we have a clear line of sight to market access, and we've got our balance sheet in the condition that we want. So it's got to be something south of CAD 5 billion net debt. And we were clear about that at Investor Day, and we would continue to reiterate that. What I will tell you is that coming out of this, we will prioritize the balance sheet in terms of free cash flow allocation. So when you think about that plan that we developed for Investor Day, that we then developed over 2, 3 years that Alex and I have taken since we got here, what really happens is it gets pushed out. This delays the timing of those potential growth modules because we need to fix the balance sheet first. And that's one of the really nice things of both this asset base is it provides you that kind of flexibility. It's not something that you need to do today. If it's not within your financial wherewithal, it can wait. And those kind of projects can be accessed later when the balance sheet is where we want it, and we've got a line of sight to that market access that I talked about.

And then in terms of getting to that $5 billion target, do you feel like there are other levers you could pull to accelerate that process, Deep Basin or anything else? I know at one point, Deep Basin was on the tables, probably difficult in this environment. But are there other things that you think are maybe available to help accelerate?

Yes. We get asked that question a lot. What I would say is I don't feel like we need to do something like that. There is no -- it's easier to tell you what I'm not going to do than what I would consider. But don't think about this as a company that's going to go out and do a royalty deal over its FCCL assets. Don't think about us selling it, infrastructure, impairing those assets going forward. We don't need to do that. And we're certainly not going to sell Deep Basin assets at fire sale prices to provide cash to the business. We don't need to do that. If there were a market for some of those Deep Basin assets, and we thought we were getting fair and full value from them, we would consider something like that. I don't think that's realistic in today's world. But we are quite comfortable with the liquidity that we've got on the balance sheet, quite comfortable with the leverage that we have to -- a rebalancing of the energy market and what that's going to do to pricing and a commitment to get our balance sheet right-sized the right way. But don't think about this as a company that is going to fire sell assets or impair the long-term viability of really what is family silver at FCCL.

Yes, absolutely. So -- and then how about the dividend just in terms of the decision to suspend it and what you would need to see to reinstate? I mean do we need to see the $5 billion of debt at this point in terms of the importance of getting to that? Or are you -- how do you think about balancing those objectives?

Well what I would say, Phil, I guess, is, as always, the dividend is a Board decision. It's -- I definitely have some input, but I'm not the final decision-maker on that. But I would tell you that returns to our shareholders are important, but don't think about us as being a company that's going to pay that out of debt, and don't think of us as a company that is going to risk the balance sheet to reinstate the dividend [ merely ]. We will be a company, as I mentioned before, that as we come out of this, the vast majority of the free cash flow is going to the balance sheet, and we need to get to those -- the targets that I talked because they put us in a sustainable condition at the bottom of the market. The one thing I would say is -- and I touched on this a little bit earlier, but this is a company that we have built to be sustainable at $45, and the dividend and shareholder returns policy is predicated on that as is our capital allocation policy and our entire financial framework as to how we keep the balance sheet and the leverage positions where they are. As we come out of this, we're going to stay focused on keeping our costs down and maintaining liquidity, but at some point, we're going to think whether or not all of those fundamental underlying assumptions still hold or whether we need to adjust them somewhat. So what I would tell you, as it specifically relates to the dividend, is the balance sheet is going to take priority. The longer we're in this and the longer it takes us to delever, that will delay the dividend. But we do recognize, at some point, returns to shareholders are very important to us and to them.

Sure. And then the $5 billion target was premised on a trough of the cycle, essentially leveraged metrics. So could you remind me what assumptions you used for that? And after this whole COVID situation, you said $5 billion is a ceiling. So anything about the situation that makes you rethink what the trough definition was?

Yes. Yes. When we put our financial framework in place, this company produces about $2.5 billion of EBITDA at $45, assuming a $13 WTI-WCS differential, $13 crack and condensate trading close to [ TI ], and I think there's a CAD 0.75 dollar there assumption as well, which really makes $5 billion of debt about 2x EBITDA at that $45. Included in that, there's about $1.8 billion of cash flow, and I mentioned that we need about $1.2 billion in sustaining capital to keep the company flat through time, and then there's about $600 million that's left over for dividends and incremental investments. So the company is truly sustainable at $45. And what we're thinking through, and what we'll put some more time and effort to at some point in the future when we're through this is there's been really 3 periods of time where we have gone below $45 over the last 15 years. One was in 2007 financial crisis, and that didn't last long. It lasted about 2 months. And then in 2016 with the OPEC issues, we went under for 4 months. And this looks like it's going to be longer and deeper than that. So as we see potential for increased volatility, it does make us think about how we need to gear this company and how we need to adjust the financial framework to deal with that kind of volatility. And then on top of that, I would just add that we have a view and a fundamental underpinning that we're in a commodity business, and commodities through time just go one direction and that's lower in price. And you've got to continue to find ways to get more efficient, more productive, beat back inflation and lower your breakeven. So all of those kind of things come into our thinking, but we're absolutely focused on the long term. We're focused on our costs. And we think if you like this company at $40, you're going to love it if we get a $60 spike at some point [ in time ].

I think that's a good way to wrap it up actually. We've hit our 30-minute target. It went pretty quickly. So Jon, thanks so much for making the time to be on this call with me today. I really appreciate it. Always good to see you and catch up, and I'm sure we'll do it again soon.

Great. Thank you, Phil, and thank you, everybody, for listening, and take care and be safe.

Thank you.