(Public) Jon Is Pounding The Table On Cenovus Energy
By: Jon Costello
Energy investors can’t catch a break. After spending months navigating geopolitical volatility and dour investor sentiment toward next year’s oil supply/demand balances, they’ve been handed a few new bearish macro variables to deal with. These include:
Fears that Trump’s “Drill Baby, Drill” mantra will lead to a torrent of U.S. oil supply.
Scott Bessent’s nomination as Treasury Secretary and his promise to boost U.S. energy production by three million boe/d.
Trump’s threat to impose 25% tariffs on all Canadian imports, including energy.
A ceasefire between Israel and Lebanon, which eliminated any remaining geopolitical premium.
Together, these variables have caused oil and E&P investors to sell now and ask questions later. But important counterpoints for each variable have gone largely unnoticed, such as:
The inability of U.S. producers to increase production anywhere close to the volumes hoped for by politicians.
Bessent cited barrels of oil equivalent in his U.S. production growth figures instead of barrels of oil. Growth comprised only of natural gas and NGLs would be consistent with his claim.
Tariffs on Canadian energy imports are highly improbable. They would increase the cost of feedstock for 20% of U.S. refined product production, thereby increasing domestic energy prices and lowering economic growth. This would represent a 180-degree reversal from Trump’s campaign pledges to grow the economy while reducing domestic food and energy prices. The tariffs would also put added pressure on the energy industry, a significant supporter of Trump’s presidential campaign.
OPEC is likely to extend its production cuts scheduled to begin in January. If agreed during its meeting this weekend, it would tighten the 2025 oil supply and demand balance.
Israel may be turning its focus away from Lebanon so I can focus directly on Iran.
The physical oil market shows no signs of impending distress. It isn’t anticipating the massive inventory builds implied in consensus paper supply/demand balances.
While investors always have to be attentive to risks stemming from domestic politics, geopolitics, and the oil market's fundamental outlook—and some of these variables are sources of meaningful risk even today—the current concerns are dramatically overstated. The collapse in energy market sentiment they have created has provided a rare opportunity to buy beaten-down energy stocks.
Cenovus is An Obvious Choice
Cenovus Energy (CVE) shares have been tossed in the bargain bin courtesy of all the factors listed above, and then some. Depressed macro sentiment, depressed E&P sector sentiment, and company-specific headwinds are all hitting the shares at once. I believe all these are temporary factors that make for a fantastic long-term buying opportunity.
For starters, CVE is a low-risk operation. Its upstream segment has outperformed expectations and is poised to grow over the next few years. The company has reduced net debt to minimal levels, nearly eliminating financial risks to shareholders during periods of low commodity prices. CVE investors can rest assured the company’s equity value will be safe under any realistic economic or oil market scenario. At the same time, they will benefit from the massive free cash flow generated at higher oil prices.
To top it off, I expect CVE shares to undergo a multiple rerating—along with the other large Canadian E&Ps—as investor focus turns to the implications of plateauing U.S. shale production over the coming years. Canadian E&Ps will be the logical alternative to U.S. E&Ps for both institutional and individual investors who seek long-term exposure to oil prices. The increased capital flows that result are likely to boost valuation multiples of well-positioned Canadian E&Ps like CVE and its peers.
CVE's Company-Specific Issues are Temporary
CVE shares have been penalized in recent months because management has yet to work out the kinks in the company's downstream operations, particularly those pertaining to its U.S. refineries.
The shares now trade at severely discounted levels. I estimate their 2025 strip free cash flow yield is 12.3%, far above Canadian Natural Resources’ (CNQ) 8.1% yield and Suncor Energy’s (SU) 9.2% yield.
If CVE shares were valued in line with Suncor, they’d trade 34% above today’s level. This is the kind of price appreciation I expect if management can resolve the outstanding downstream issues.
Despite the persistence of CVE's downstream headwinds, I haven’t lost faith in management's strategy and ability to integrate the company's upstream and downstream. This year alone, CVE has spent hundreds of millions of dollars to improve its U.S. refinery operations, and I expect the turnaround to bear fruit over the next few quarters.
Longer term, the benefits of CVE's integrated operating strategy will become apparent once Canadian production exceeds available pipeline takeaway capacity, which appears likely to occur in the 2026-2027 timeframe.
The fact of the matter is that Canadian oil producers are poised to grow over the next few years. Witness MEG Energy’s (MEG:CA) approval of a plan to grow its production by 25% by 2027. MEG’s growth plan comes on top of those of CVE, Canadian Natural Resources (CNQ), Strathcona Resources (SCR:CA), Veren (VRN), Obsidian Energy (OBE:CA), International Petroleum (IPCO:CA), and many other smaller E&Ps. Once this new production exceeds regional takeaway capacity, the differential between WTI and the Canadian oil benchmark, WCS, is likely to blow out until additional pipeline capacity can once again provide egress for all regional production. Unfortunately for Canadian E&Ps, new pipeline capacity won’t be available for many years.
CVE’s ownership of refineries allows it to evade the WCS discount applied to its upstream production. By sending its crude to its own refineries, it can capture the WTI-WCS differential as well as the refining margin between crude oil inputs and refined product output.
However, CVE doesn't have to send its crude to its refineries if market conditions favor third-party oil sales. Its marketing flexibility allows it to maximize free cash flow and return on capital.
When the WTI-WCS differential blows out, CVE’s operating model will be viewed far more favorably than it is today. The robust cash flow profile that results from its integrated model will boost its valuation multiple to higher levels. If the company can improve its return on capital, as I expect, its valuation multiple is likely to be on par with that of Suncor.
And what if CVE fails to turn around its refineries? Most likely, it will separate them from the rest of its business.
The company-specific issue holding back CVE's stock is therefore likely to be resolved in one of two ways: either the downstream performance improves, or the downstream segment gets separated from upstream operations. CVE investors win either way.
If CVE's refineries continue to underperform and end up getting sold at a loss, I expect its shares to respond with a rally, as the upstream segment will emerge unburdened by the downstream drain on its cash flow.
Alternatively, perhaps the refineries get spun off as a standalone entity that maintains a favorable business relationship with CVE. This outcome would also be positive for its shares.
Whether refineries improve or get separated, either would represent a positive catalyst for its shares. The fact of the matter is that CVE's management and board members have millions of dollars of options tied to the company's share price. Insiders have also purchased shares amounting to several million dollars in the open market over the past few years. The large shareholdings among insiders create an incentive to increase shareholder value and the share price. And if existing management isn’t up to the job at hand, I expect it to be replaced by a team that can resolve the ongoing issues.
Despite CVE's Challenges, My Thesis Remains on Track
CVE investors will have to persevere through times like these, when the stock languishes due to macro bearishness and company-specific issues. In a cyclical and volatile sector like energy, they're the price the investor pays for long-term outperformance. No investor can anticipate precisely how or when these negatives will surface. An investor can only be confident that they'll occur at least once or twice over a multi-year holding period.
We’ve held CVE shares in our Energy Income Portfolio since May 2023, when I bought them for the portfolio at $15.85. Since then, the shares have traded as high as $21.90 and now trade near their lows.
Despite the volatility, my CVE thesis hasn’t changed. The next leg of the thesis involves the successful resolution of the refining issues over the next few quarters. If the refineries continue to underperform, I expect that they'll be separated from upstream at some point over the next two years. In either scenario, the shares are likely to trade significantly higher than today’s depressed level.
CVE investors who hold for three to five years are likely to earn attractive total returns once the shares trade into the mid-$20s and higher over the coming years, as I expect.
Shareholder-Friendly Capital Allocation
CVE is now distributing 100% of its free cash flow to shareholders. If—or, more properly, when—WTI increases above the $80 per barrel level, and assuming CVE improves its downstream operations, the company will become a free cash flow machine. Its free cash flow yield on today’s share price will comfortably exceed 20%, and all its free cash flow is likely to be distributed to shareholders. Over time, large dividends and share repurchases will increase the investment returns earned by CVE shareholders throughout the oil market cycle.
The company’s latest capital allocation move—announced last Monday—was the redemption of its Series 3 Preferred, which is likely the beginning of several preferred share redemptions. While the move will reduce cash flow available for common share repurchases, it will eliminate needless financing that was a holdover from CVE's 2020 Husky Energy acquisition.
CVE’s next capital allocation move will likely be an increase in its quarterly base common dividend, which I expect to occur in the first half of 2025.
Operationally, growth will build additional shareholder value. CVE’s 30,000 bbl/d Narrows Lake is expected to start up next year. Investors will then look forward to the 45,000 boe/d West White Rose project startup in 2026. These downstream growth initiatives mean that in the event the company has to shed its refineries, prospects for its shares will improve from steady production growth and the resulting growth in free cash flow per share.
Conclusion
John Templeton famously counseled investors to buy during the period of “maximum pessimism.” In that vein, the best time to buy E&Ps is when they’re most beaten down. As an investor who's been in the E&P game for many years, I can confirm that today's conditions qualify. Sentiment is in the dumps. The oil market's near-term outlook appears challenged. Temporary operational issues cast a pall over a company’s prospects. All these situations reverse in due course. As they do, E&P stock prices recover.
CVE offers a case in point. Investors should buy during today’s doldrums to benefit from a much brighter future over the coming years.
Analyst's Disclosure: Jon Costello has a beneficial long position in the shares of CVE, VRN, MEG:CA, SCR:CA either through stock ownership, options, or other derivatives.