Cenovus Energy Inc

NYSE:CVE

Earnings Call Transcript 2020-Q2

[Operator]

Good day, ladies and gentlemen, and thank you for standing by. Welcome to Cenovus Energy's second quarter results. As a reminder, today's call is being recorded. [Operator Instructions] Please be advised that this conference call may not be recorded or rebroadcast without the expressed consent of Cenovus Energy. I would now like to turn the conference call over to Ms. Sherry Wendt, Director, Investor Relations. Please go ahead, Ms. Wendt.

[Sherry A. Wendt, Director of Investor Relations]

Thank you, operator, and welcome, everyone, to our second quarter 2020 results conference call. Due to COVID-19 physical distancing guidelines, we do not have the entire leadership team together in the conference room downtown. Here with me is our President and Chief Executive Officer, Alex Pourbaix; our Chief Financial Officer, Jon McKenzie; our chief -- our Executive Vice President, Upstream, Norrie Ramsay; and our Executive Vice President, Downstream, Keith Chiasson. They will answer your questions while the other leadership team members are in listen-only mode today from other locations. I refer you to the advisories located at the end of today's news release. These advisories describe the forward-looking information, non-GAAP measures and oil and gas terms referred to today and outline the risk factors and assumptions relevant to this discussion. Additional information is available in our annual MD&A and our most recent annual information form and Form 40-F. The quarterly results have been presented in Canadian dollars and on a before royalties basis. We have also posted our results on our website at cenovus.com. Alex will provide brief comments, and then we will turn to the Q&A portion of the call. We would ask analysts to hold off on any detailed modeling questions and follow up directly with our Investor Relations team after the call. [Operator Instructions] Please go ahead, Alex.

[Alexander J. Pourbaix, CEO, President & Director]

Thanks, Sherry, and good morning, everybody. I hope all of you are continuing to stay safe and healthy. And although our economy is starting to open up, it's clear we're still far from being able to look in the rearview mirror at the impact of COVID-19. I want to just start first off by giving credit to our staff at Cenovus for keeping our operations running safely and reliably and for adapting to all the additional measures we've put in place in response to the pandemic. It really has been incredible to witness the resiliency of our people and their dedication to looking out for one another. The field staff have been diligently following the new procedures to prevent the spread of the virus at our sites and camps, and staff have embraced technology to remain productive while working virtually. Through all of the changes, our teams remained focused on safety performance. And as an example of that, we had 0 significant incidents across our operations in the first half of the year, and our Deep Basin team achieved a milestone of 0 recordable injuries for an entire year, which I think is truly impressive given the conditions that our employees and staff have had to work under. While some of our staff who were working remotely have gradually started returning to their regular job locations, we are proceeding cautiously to help ensure the safety of our people and the reliability of our operations. I want to provide details now about our response to the recent downturn, likely the worst quarter our industry has witnessed in recent memory. The second quarter presented commodity price instability beyond what anyone, I think, ever could have predicted. The sharp drop in oil demand and resulting unprecedented low oil prices experienced early in the quarter had a significant impact on our financial results, but the extreme volatility also highlighted what sets Cenovus apart from our peers. It presented an opportunity for our marketing and upstream teams to demonstrate why shareholders should have confidence in this company. We are able to leverage our low-cost structure and the flexibility of our assets to strategically access the highest returns for our products and maximize value for shareholders. In response to the sharp decline in oil prices in April, we quickly reduced production volumes at our oil sands operations while continuing to steam and store the mobilized oil in the reservoir. When the average price of Western Canadian Select increased almost tenfold in June compared with April, we acted fast to ramp up our oil sands production back up to take advantage of the improved pricing. Our well cost structure means that with WCS prices at current levels, we are generating free funds flow and strengthening our balance sheet.During the quarter, essentially all the inventory that we wrote down in March was sold, and we realized the inventory write-downs. That reduced adjusted funds flow and free funds flow by $529 million. Excluding the impact of these write-downs from the first quarter, we would have had positive adjusted funds flow of nearly $70 million in Q2. We've also been purchasing low-cost production credits from peers so that we can produce above our curtailment limit. That allowed us to push our June oil sands production to more than 405,000 barrels per day, including record volumes at our Christina Lake facility. I cannot overemphasize the value of our ability to take advantage of rapidly changing market conditions. In April, when WCS prices were less than $5 per barrel, we voluntarily reduced oil sand production to an average of just under 344,000 barrels a day. In June, when prices were nearly 10x that, we ramped up production by 60,000 barrels a day, a more than 17% increase that happened over just a few weeks. At Christina Lake specifically, there was an 80,000 barrel per day difference from our lowest daily production in the second quarter to our highest day in June. Our Downstream business is designed for flexibility as well, providing opportunities in terms of both timing and location of sales. This meant that in addition to timing our production over the past months, we're also able to use our diversified transportation and storage portfolio to defer sales from April into June when we were seeing higher price signals. The close working relationship between our marketing and operation teams are giving us a competitive advantage. Their quick action in June resulted in free funds flow for the month of more than $290 million. Meanwhile, the flexibility of our refineries meant that refining runs could be adjusted to take into account refined product demand signals to maximize value for our shareholders there as well. We believe we're on the way to recovery from the low point in the downturn in April, although we expect commodity price volatility for the foreseeable future. We are not counting on a swift recovery. Second only to the safety of our staff, balance sheet strength remains our priority. This downturn demonstrated the value of our relentless focus on paying down debt, reducing costs and maintaining capital discipline over the past years. You will continue to see that discipline at Cenovus. We finished the quarter with net debt at around $8.2 billion. We remain committed to getting net debt down to $5 billion or below over the longer term. Given the outlook for pricing in the second half of 2020, we anticipate the level of net debt at the end of the second quarter to be the high point for the year. We have worked to ensure we continue to have ample liquidity to withstand a continued period of low oil prices if necessary, and we remain focused on disciplined capital spending. We will be sticking with the reduced 2020 capital budget we announced in April even if the price environment improves over the coming months. Before I turn to your questions, I want to encourage everyone to check out our environmental, social and governance report that we released last week on cenovus.com. This report provides context for the analysis we performed before setting our ESG focus area targets earlier this year as well as details of our 2019 sustainability performance. We are committed to achieving those targets and to continuously improving our ESG reporting to ensure our shareholders and other stakeholders are fully informed about our performance. I feel this report really raises the bar for our industry when it comes to sustainability disclosure. With that, I'm happy to take your questions.

[Operator]

[Operator Instructions] First caller comes from Greg Pardy with RBC Capital.

[Greg M. Pardy, MD & Co]

A couple of questions. I guess the first one is -- you mentioned that $5 billion has gone kind of from the target to the upper boundary. As you maybe look at the new world in terms of where oil prices might shake out or what kind of volatility we're facing, is there a lower boundary maybe even in the 3s that you'd be sort of looking at as maybe optimum, optimum in terms of like running a really underlevered balance sheet going forward?

[Alexander J. Pourbaix, CEO, President & Director]

Yes. Thanks, Greg. I think it's a really good comment. And I think Jon and I have been quite pointed over the last few months about talking about $5 billion is ultimately an upper band. And I think the easiest way for me to answer that would be to say that our balance -- nothing has emphasized for me the importance of balance sheet than the past 4 or 5 months. And it is not going to cause me any loss of sleep at night -- if we don't see compelling opportunities, driving that net debt down below $5 billion is not going to cost me any sleep. And I think that's probably -- directionally, that's probably something that our investors should be thinking about.

[Greg M. Pardy, MD & Co]

Okay. Terrific. And then maybe a question for Jon maybe just around the hedging. I mean we picked up the hedges you put in. So you've sold, I don't know, 88-odd thousand, and then you've got purchases for 56,000, fixed prices. There's a little bit of a differential there, and there's a little bit of work you guys did on the spread. But how should we think about hedging and maybe why those were put in place what have you?

[Jonathan M. McKenzie, Executive VP & CFO]

Yes, Greg. What I would tell you is that at a corporate level, nothing has changed. We still see the balance sheet is the right way to ultimately hedge our operations. But one thing you do need to understand about this company is we do have substantial pipeline and storage assets that we use on a daily, monthly basis to optimize our pricing. So the hedge losses that you'll see both on a realized and unrealized basis in the financial statements of Q2 are really related to the optimization work we do in locking in margins around those assets. What we saw in Q2 was some pretty significant contango opportunities in particular, where those assets were quite valuable to us. So I'll just give you a quick example of how that works on an accounting basis so you're not surprised on a go-forward basis. But if the marketers have an opportunity in May, for example, to sell at $20 or sell forward in June, for example, at $24, we can realize a margin of $4 by storing those barrels for a month and selling them in June. So what they'll do is they'll forward sell them and use a financial derivative to lock in that $4. On the accounting side, what we'll show is -- for example, if June then closes at $40, we'll show a $40 realization but a $16 hedge loss. So we've locked in the $24 in the month that we'd do it, but what the accounting does is it separates that transaction. So when you see contango opportunities and you see WTI rising through a quarter like this, that's kind of the result you're going to see on a go-forward basis, but it really reflects what we've done to kind of lock in margins as a company.

[Greg M. Pardy, MD & Co]

Okay. So I get the sales part. It's -- and I don't want to get too far in the weeds here, but there were also -- you've also got like purchases, right, at a couple of bucks higher. Is that related to the same thing?

[Jonathan M. McKenzie, Executive VP & CFO]

It's all the same thing.

[Operator]

Next question comes from Emily Chieng with Goldman Sachs.

[Emily Christine Chieng, Associate]

Maybe as a follow-up from Greg and to really double down on the message here, but net debt is back to early 2019 levels. And when you think about the deleveraging process ahead of you this time around, are there any sort of interim targets to look for before you maybe switch the dividend back on? Or are you now simply concentrating on hitting that $5 billion net debt before we consider other areas to deploy capital?

[Alexander J. Pourbaix, CEO, President & Director]

I think from our perspective, absolute priority is the balance sheet until we get that debt back down to a level that we're a lot more comfortable with. And so I would not expect to see anything that would have us deviate materially from that in the near future.

[Jonathan M. McKenzie, Executive VP & CFO]

Yes. Emily, it's Jon. I would just add on to that. We are, as a company, still focused on the 3 things that Alex has talked about in depth: maintaining costs, balance sheet integrity as well as liquidity. So although we see a lot of green shoots coming out of June and we had a very good month, we are laser-focused on generating free cash flow through the next few months and applying that to the balance sheet before we consider reinstituting the dividend.

[Emily Christine Chieng, Associate]

Great. That's super clear. And one follow-up, if I may, just around spreads. They've been very tight over the second quarter. But as you think about production ramping up in Canada, how do you think about where the light-heavy differential comes out towards the back end of the year? And when do you think production levels in Canada as a whole return to pre-COVID-19 levels?

[Alexander J. Pourbaix, CEO, President & Director]

Emily, why don't I hand that off to Keith. And he can give his view, and I might add a little bit of color.

[Keith A. Chiasson, Executive Vice]

Emily, thanks for the question. And what I would like to say is, when we were sitting in April, we ramped down production. And then coming into June, we saw what I would say record tight differentials. And I think between the low in April to the high in June, we've increased production at Christina Lake by 80,000 barrels a day to capture that record tightness and generate significant free funds flow in the month. As we look forward, that opportunity prevailed because there's significant upstream production off in Canada, and we think that persists through the summer months. But rightly, as you indicate, as we head into the fall, there could be some additional production coming back on. Now it's uncertain. We think that currently, there's over 500,000 barrels a day still offline in Western Canada. And it's uncertain how much of that actually does come back. But it's something that we will watch very closely. And obviously, we -- if we do see the differential widen and there are economics to restart our rail program for a longer period of time, we will look at that opportunity if it makes economic sense.

[Operator]

Next question comes from Phil Gresh with JPMorgan.

[Philip Mulkey Gresh, Senior Equity Research Analyst]

First question, just -- I guess I'll ask one more on the deleveraging. And Jon, I probably asked you this in the past, but is there anything else you think you could do inorganically to accelerate the process of deleveraging, asset sales or otherwise that you would think about, maybe not in this exact environment but as you look ahead, say, 12 to 18 months? Or would you say this is just going to be more of an organic process?

[Jonathan M. McKenzie, Executive VP & CFO]

Yes, Phil. I think for your modeling purposes and for general assumptions, you should think of this being an organic process. One thing we've been really clear about is we're not going to do anything to impair the value of FCCL. We certainly see that as family silver, and we're not going to do something in the short term that's going to have long-term implications to the value of that asset. As it relates to the Deep Basin, we've been pretty clear. We've stood down any kind of inorganic process there. We don't think that transaction values today reflect the long-term value of that asset as well. And then we're pretty happy with, obviously, WRB, which provides us the countercyclical cash flow and insulation against some of the heavy oil and -- differentials that we see in Western Canada. So by and large, you should just assume it's going to be organic.

[Philip Mulkey Gresh, Senior Equity Research Analyst]

Okay. Understood. Second question would be just on the commentary about the June cash flow. Obviously, very strong for the month. Would you say that, that is sustainable as you move through the third quarter? Or were there any onetime factors that contributed to such a strong result on the month. I'm thinking maybe lagged condensate or something else. I'm just curious how you think about the rest of the year playing out.

[Jonathan M. McKenzie, Executive VP & CFO]

Yes. Phil, when you look at June, you're absolutely right, it was a terrific month. And there's pieces of June that I would describe as onetime in order of magnitude, but thematically, going forward, they still exist. Two big drivers for June. One was the differential -- the WTI-WCS differential narrowed to just over $4. So even on a historical basis, that is an extremely tight differential. And then some of the condensate that we were purchasing in April and May started to flow through those June numbers. So in terms of order of magnitude going forward, I don't think you'll see the same kind of performance. But do realize that the differentials are still narrow for both July and August, and the condensate pricing is still quite favorable. So though I don't expect July, August to be as good as June, directionally, they're consistent with June.

[Operator]

Next question comes from Manav Gupta with Crédit Suisse.

[Manav Gupta, Research Analyst]

Delving a little bit on this inventory adjustment of $329 million. Is it a onetime? What contributed to it? And should we assume none of it comes back as we go ahead. This is in the oil sands segment of yours.

[Jonathan M. McKenzie, Executive VP & CFO]

Sure, Manav. I think the question was on the inventory build on the balance sheet.

[Manav Gupta, Research Analyst]

Is the $329 million charge that you're booking on your operating margin?

[Jonathan M. McKenzie, Executive VP & CFO]

Yes. So what you'll remember is at the end of Q1, we wrote off, I think, $588 million of inventory. And what you see is that start to come through in the month of April in particular. So we realized those inventory write-downs that we took at the end of Q1 on a cash basis in Q2. So the total inventory charge that we saw come through was 300 and some on the oil sands side and the residual on the downstream side.

[Manav Gupta, Research Analyst]

Okay. And one quick follow-up, sir. Obviously, June was very strong. But when we look at the netbacks on both Foster Creek, Christina Lake, they're negative for the quarter. So should we assume, basically, you had a very bad April and then things improved a little in May and then they really improved in June? Is that the right way to think about it?

[Jonathan M. McKenzie, Executive VP & CFO]

Yes. What you should think about in terms of those netbacks is April was very weak as we realized those inventory write-downs and then June was substantially better. So even with -- I think the price of WTI went from 16 to 38 through the quarter, and it was even more dramatic on the WCS side, where I think we went from 3 to 40 -- sorry, 3 to 34. So what you've seen through the quarter is a period of improving performance. But on average, it looks relatively weak when you take into account the inventory write-downs. But June was much, much better than what you see for an average.

[Manav Gupta, Research Analyst]

Perfect. And the last question is you have temporarily suspended your Foster Creek railcar program. And in the quarter, the transporting -- transportation and lending cost has actually started to trend down. So I'm just trying to understand, should we assume a more trending downward as the rail remains suspended? Or this was also a function of our condensate pricing?

[Alexander J. Pourbaix, CEO, President & Director]

Sorry, you're thinking of the rail program? Was that the question, Manav?

[Manav Gupta, Research Analyst]

Yes. So I mean I'm just trying to look at the transportation and blending cost at Foster Creek. It started to come down from $14.37 to $11.32. I'm just trying to understand, has the suspending of the rail program helped you out over there?

[Jonathan M. McKenzie, Executive VP & CFO]

Yes. No, absolutely, it has. And if you look at rail on a fully loaded basis to move 100,000 barrels a day of crude at Bruderheim, we were spending about $80 million a month. Now that we've ramped it down, we're incurring just the fixed charges, which is about $18 million to $20 million. So that all gets reflected in the transportation cost. Now it doesn't all go to Foster Creek. It really depends on which barrels we move. So it can be both. But the true savings is about $60 million a month, which is reflected across the company in our transportation costs.

[Operator]

Next question comes from Benny Wong with Morgan Stanley.

[Benny Wong, Vice President]

My first question is around your production profile in the back half of the year. Obviously, you guys exited the quarter with very strong volumes. I'm assuming oil prices will be a factor but also wanted to get your thoughts around availability to utilize more curtailment credit. Especially at the back half of the year, there's going to be less industry maintenance activity going on. And on the refining demand side, still relatively soft to normal levels. Just wanted to get your thoughts around how you think about that.

[Alexander J. Pourbaix, CEO, President & Director]

Yes, Benny. I mean we certainly were able to take advantage in Q2 of some really attractively priced credits. And I think the word is out, and we've seen those -- they've increased somewhat in price, but maybe I'll let Keith kind of comment on what we think for the balance of the year.

[Keith A. Chiasson, Executive Vice]

Yes. Thanks for the question, Benny. As we look through kind of the back half of the summer, there still is significant turnaround activities happening in the industry that's keeping a fair amount of production offline. So availability of those credits to be able to produce, we think, is going to be there. As we head into the back half of the year, there's still a big question mark about how much of that production actually does come back, and that will really drive the availability of acquiring those credits. But I would reiterate that if the differentials do widen, we do have a rail program there that can generate production credits as well. And the way we stopped the program is in a fashion that we have our cars stored at both our Bruderheim facility and some of our U.S. destinations to enable us to quickly ramp the program back up if the economics make sense and we see a structural reason to want to do that for a longer period of time.

[Benny Wong, Vice President]

That's great. Keith, appreciate your thoughts there. My follow-up is more for Alex. I guess I just wanted to tap into your extensive midstream and pipeline experience and get your perspective around the headlines we've been seeing around Line 5 and DAPL. How do you think about the risk, particularly if you see an extended shutdown of those pipelines? And just more broadly, is this an early indication of an even tougher environment ahead of us for just energy infrastructure overall?

[Alexander J. Pourbaix, CEO, President & Director]

Yes. I mean it's a really good question, Benny. And I wish -- I'm not sure my experience gives me any deeper insight. But I guess I'd respond maybe specifically to Cenovus, and then maybe I'll respond more broadly. With respect to our business, we're -- we don't see DAPL or Line 5 really having significant implications for our business. We do think it could obviously have some impact on the lighter grades. But for us, we're not -- we don't see it as particularly material. But I think as an industry, my own personal observation, DAPL I think is a great example of a pipeline that went through an incredibly exhaustive environmental review and regulatory process, which finally, after extended debate, it received all of its permits. It's been in operation for 2 or 3 years, and we now have a judge who is -- who believes that it's appropriate to take that infrastructure out of service while we debate the environment -- some environmental aspects. So I think that's quite concerning. And I hope it is -- I hope that the legal issue is dispensed with very quickly, and everything gets back to normal. And this is not an issue for the oil industry. I mean we're seeing this on basically all infrastructure across North America, so I think it is a significant issue. From my perspective, I -- we identified -- probably the first day I got here, I identified that one of the biggest challenge for Cenovus was market access and egress. And as I've said to many people, hope and prayer isn't a strategy, and we need to have plans particularly in a world where we may see continued challenges to pipelines. And that's why you've seen us do the things we've done to secure more pipeline capacity, the work we've done on supporting Enbridge's contract carrier regulatory application and the early work that we did on the DRU. And all of that was from a perspective of creating options in a world where it might be more challenging.

[Operator]

Next question comes from Asit Sen with Bank of America.

[Asit Kumar Sen, Research Analyst]

If I could go to Slide 10, which was, I think, fairly interesting, on Christina Lake production volumes and I think shows that you've managed your volumes pretty well with WCS. And I think, Alex, you mentioned 80,000 barrels a day swing. My question is, Christina Lake has low SOR and a low operating cost, I think, in the $6 to $7 range. How does operating costs fluctuate when you shift volumes this sharply? Is there an impact on operating costs?

[Norrie C. Ramsay, Executive Vice]

It's Norrie Ramsay here from the Upstream business. What we did, obviously, in April is reduce our production at Christina Lake and then brought back up again in June. So for a short period of time, our steam oil ratio went from what was normally 2 up to 2.1. It will go back down sub 2 again throughout the year. So relatively speaking, it just stays flat. We are 15% year-on-year down from 2019. But our OpEx will stay within the guidelines that we've provided earlier.

[Asit Kumar Sen, Research Analyst]

Okay. And then my question on third-party credits that you acquired in May and June, any thoughts on pricing? How much does it cost you? And then looking forward in the back half of the year, there were comments made on that, but how about the magnitude, availability of credit? How should we think about that?

[Alexander J. Pourbaix, CEO, President & Director]

Well, Asit, we can't give up all of our commercial secrets, but why don't I let Keith respond to that?

[Keith A. Chiasson, Executive Vice]

Yes, Asit. Obviously, pretty commercially sensitive information, but what I would say is what we saw through the second quarter was significant upstream production turned off. So the availability of those credits, they're readily available. We see that kind of persisting through the back half of the summer, kind of the July, August time frame as turnarounds are getting extended in -- with some of our peers, and therefore, more production remains offline than maybe originally envisioned. What I would say, as you head into the fall, obviously, doing turnarounds in Canada in the winter is not a good idea. So we do expect some of that production to come back. And the critical part will be relative to the overall curtailment levels the Alberta government has set and the amount of production offline and the amount of rail that's moving. Are we in an essentially balanced market or is there additional egress challenges? And then how quickly does rail ramp up to meet those egress challenges? All of that will then determine kind of where the differential settles and the economics of railing. And the government also has the program in place that if you rail, you do generate additional production credit. So in an economic -- where that makes sense economically, we would look at turning our program back on.

[Asit Kumar Sen, Research Analyst]

Appreciate the color. Keith, just -- is the credit market fairly liquid?

[Keith A. Chiasson, Executive Vice]

Yes, it's fairly liquid. I mean it kind of runs month-to-month during...

[Operator]

[Operator Instructions] And we have a question from Joe Gemino with Morningstar.

[Joseph J. Gemino, Senior Equity Analyst]

Just got a quick question as you think about your balance sheet. If you do generate free cash flow for the rest of the year, do you anticipate putting it in paying down your revolver or maybe some of the -- putting it for eventual maturities that start to come up in the next few years?

[Jonathan M. McKenzie, Executive VP & CFO]

Yes. Joe, it's Jon. No, you're right in your thinking that the dollars today would go to the revolver versus into the bond market. Now that all being said, we are thinking about our '22s and our '23s and how we would refinance those going forward. So it all comes into our thinking. But over the short term, any free cash flow is really going to get applied to our banking facilities.

[Operator]

[Operator Instructions] And we do not have any questions at this time. I will turn the call over to Ms. Wendt.

[Sherry A. Wendt, Director of Investor Relations]

Thanks, operator, and thanks, everyone, for joining us today. That concludes the Q&A and concludes our call. Have a great day.

[Alexander J. Pourbaix, CEO, President & Director]

Thanks, everyone.

[Operator]

This concludes today's conference call. You may now disconnect.