Judging by how investors have treated Cenovus Energy Inc., you’d think the company had suffered some sort of fundamental deterioration.
Long upheld as a darling of the oil sands, Cenovus stock has trailed the S&P/TSX Capped Energy Index by 20 per cent over the past year, with shares hitting a three-and-a-half-year low in February.
Granted, the evolution of Foster Creek, its largest producing project, has not exactly gone smoothly. But little has changed in Cenovus’s growth prospects and earnings power to deserve the market’s enduring discontent.
“We believe the noticeable underperformance of the shares in 2013 has created an attractive buying opportunity for what we believe to be a top-tier energy company,” Chris Cox, an analyst at Raymond James, said in a recent note.
Investors have long afforded Cenovus stock a substantial valuation premium over its peers as a result of its high growth, superior returns on capital and low costs, which make the company less susceptible to commodity price fluctuations.
Over the past few years, that premium has steadily dwindled. About three years ago, Cenovus was trading at an enterprise value of 11 times forward earnings before interest, taxes, depreciation and amortization. It’s now trading at 6.2 times 2014 EBITDA, which compares to an average of 5.9 times for other Canadian integrated oil companies as of mid-February, according to Mr. Cox.
The problem: first mover disadvantage.
In 2002, Foster Creek in Alberta became the first commercial steam-assisted gravity drainage (SAGD) operation. Instead of mining the oil sands, SAGD projects use steam pumped underground through one well to liquefy the bitumen, which is extracted from a second well.
As Foster Creek has matured, the steam has caused chambers from separate wells to merge into so-called “mega chambers,” requiring the company to reconsider its extraction methods.
All SAGD operations will encounter this problem. Cenovus is stuck with the burden of figuring it out first through trial and error. There have been plenty of errors.
Through 2013, production at Foster Creek fell by 8 per cent, operating costs rose by 32 per cent and the company’s use of steam crept higher.
Cenovus’s low steam-to-oil ratio, a metric closely watched by analysts, is expected to rise to an average of between 2.6 to 3 this year at Foster Creek, well above the low 2s that have kept the project, and the stock, in high regard.
The company announced in February that it was tweaking its method and delaying the expansion of some phases of Foster Creek.
Investors got spooked, sending the stock down as much as 4.7 per cent over the next few trading days.
“There is still some concern about whether there is a long-term problem – we certainly do not believe that is the case,” said Desjardins Securities analyst Justin Bouchard, who has a $39 (Canadian) target share price on Cenovus. Analysts covering the stock have an average target price of $36.34, which represents a 23-per-cent premium over Friday’s closing price.
“If 2013 was an educational year at Foster Creek, we view 2014 as a year of applied learning.”
Last year was, in fact, a forgettable one for the entire Canadian energy sector, as foreign investors pulled money from Canada for a variety of reasons both industry-specific, such as a shortage of pipeline capacity, and otherwise.
Warren Buffett went in the other direction, revealing in a regulatory filing a position in Suncor Energy Inc. It made sense, given Mr. Buffett’s fondness for free cash flow, which Suncor generates in abundance.
“That had a big effect on how the U.S. market viewed this space,” said Ryan Bushell, portfolio manager at Leon Frazer. “It put an emphasis on free cash flow generation and Cenovus isn’t there yet.”
The company’s projects require great capital outlays at the moment, but that will change once Foster Creek gets back on track, Mr. Bouchard said.
“We see Cenovus as one of the best generators of free cash flow over the next several years,” he said in a note.
And in the meantime, Cenovus, whose stock is yielding 3.6 per cent, will pay you a healthy dividend for your trouble.