Morningstar Magazine - February/March 2018 - 53

Cracking High Costs
SAP technology sets Cenovus apart from its peers.

BEST IDEAS: EQUITY

Joe Gemino

Cenovus Energy CVE

This article is adapted from a Morningstar equity research report dated
Dec. 14, 2017.

Stats 12/31/2017

Cenovus Energy CVE operates as an integrated oil company, focused on
creating value through the development of its oil sands assets. The company
also engages in production of conventional crude oil, natural gas liquids,
and natural gas in Alberta and Saskatchewan, Canada, with refining operations
in the United States.
Oil sands projects have long been characterized by high capital requirements
and production costs and require higher West Texas Intermediate breakeven prices compared with conventional oil projects. Cenovus' cost structure
is greatly affected by the distance required to transport its product to U.S.
refineries. Limited pipeline capacity to transport production to U.S. refineries
exists, and rail transportation, which provides additional outlets, is more
expensive. Transportation logistics and the associated costs, coupled with
bitumen's heavy and sour oil composition, result in low price realizations
for Cenovus' blended product when compared with crude oil benchmarks. After
subtracting the costs of condensate, bitumen realization differentials can
range from 30% to 55% when compared with WTI. Consequently, most
expansion projects aren't economical at $55 per barrel of WTI and struggle to
compete with other global supply sources.
It appears that Cenovus has found its solution with its solvent-aided process,
or SAP, which holds the potential for the lowest-cost oil sands production in
the industry. We expect the implementation of SAP technology to provide
Cenovus with the cost savings needed to be competitive with other marginal
supply sources and generate free cash flow in a $55/bbl environment.
Based on our analysis, the solvent-aided process could eventually be
the lowest-cost oil sands production, with most potential production having
break-even prices around $45/bbl WTI. Cenovus' recent acquisition of the
remaining interest in the Foster Creek Christina Lake Partnership provides the
company with additional opportunities to showcase its industry-leading
cost structure. As a result, Cenovus should be able to generate positive cash
flow in our midcycle environment.
Implementing the SAP technology is still a few years out, and the company
will not benefit from these cost reductions today. In the meantime, the
company will continue to be plagued by higher cost structures on its existing

Morningstar Rating
QQQQ

Sector
o Energy

Industry
Oil & Gas Integrated

Price
$9.13

Fair Value Estimate
$16.00

Uncertainty
Very High

Economic Moat
None

Stewardship Rating
Standard

Market Cap
$11.2 Billion

Price/Fair Value 12/31/2017

$40
30
Price

16.00
20

Fair Value Estimate
01/2015

9.13
01/2016

01/2017

bitumen production. Therefore, under the current extraction process, the
combination of intensive capital requirements, high transportation costs, low
price realizations, high break-even prices, and delay in implementing
solvent-aided production hampers Cenovus' ability to generate excess returns
on invested capital when we reach our midcycle price forecasts. As such,
we do not consider the firm to have an economic moat.
However, Cenovus maintains a strong balance sheet, and we expect its solventaided process to drive meaningful value in the long term. While significant
oil sands growth is a few years away, we think the market is too narrowly
focused on the company's temporary increase in leverage and vastly underestimating the potential of solvent-aided production. Our model indicates
a fair value estimate of $16 (CAD 21) per share. As a result, we believe the stock
is vastly undervalued today and presents an attractive opportunity for
long-term investors. K
Joe Gemino is an equity analyst with Morningstar Research Services.

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Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2018