DBRS Provisionally Rates Cenovus Energy Inc. at A (low)

DBRS has today assigned a provisional rating of A (low) to the Senior Unsecured Debt of Cenovus Energy Inc. (Cenovus).

The assignment of the provisional rating follows the announcement by EnCana Corporation (EnCana) that its Board of Directors has unanimously approved a proposal (the Transaction) to spin off its Integrated Oil and Canadian Plains divisions into a new entity, Cenovus. The Transaction would result in two energy companies going forward: (1) an integrated oil company (Cenovus) with enhanced oil recovery oil sands properties in western Canada and interests in two refineries in the United States through its joint venture with ConocoPhillips (COP), supported by mature oil and gas properties in western Canada (primarily in Alberta and Saskatchewan); and (2) a pure play natural gas company (post-Transaction EnCana), with a North American portfolio of early life, diversified natural gas resource plays fairly equally split between Canada and the United States in major gas basins in the Canadian Foothills, the Rockies and Texas. Of EnCana’s current production and proved reserves at year-end 2008, approximately two-thirds would remain with post-Transaction EnCana and Cenovus would own one-third. The Transaction was originally proposed in May 2008 (the May 2008 Proposal) and postponed in October 2008 due to unfavourable financial market conditions. The Transaction is anticipated to close November 30, 2009, subject to court, regulatory and shareholder approvals and is not expected to be taxable from a corporate and shareholder perspective. The restructuring of the Canadian businesses would increase 2009 cash taxes by approximately $700 million. This would be partly offset by related tax benefits of about $500 million in 2010. The go-forward expenses of the Transaction are expected to be less than $200 million on an after-tax basis.

EnCana has stated that Cenovus will initially pursue the same financial strategy and use the same credit metric targets as EnCana currently employs, and that Cenovus will be appropriately capitalized for its business model and growth strategy. The metric targets include a debt-to-capitalization ratio of 30% to 40% and a debt-to-EBITDA ratio of one to two times. DBRS expects Cenovus to manage within the lower half of these ranges in order to maintain the current rating. EnCana also expects that the initial combined dividends of Cenovus and post-Transaction EnCana will approximate its current dividend of $1.60 per share annually.

DBRS expects initial pro forma net debt-to-capitalization (on a DBRS-defined basis) for Cenovus to remain close to EnCana’s level of 26% as of June 30, 2009 (32% as of March 31, 2008 at the May 2008 Proposal) and is to be maintained in the low 30% range in order to maintain the current rating. Cenovus would be paying approximately $3.5 billion in cash at closing to EnCana to acquire its Integrated Oil and Canadian Plains divisions. Cenovus has obtained a committed and fully underwritten $3 billion non-revolving 364-day bridge financing facility to partially fund the amount to be paid to EnCana. In addition, Cenovus has obtained a committed and fully underwritten CAD 1.5 billion three-year revolving credit facility and a CAD 500 million 364-day revolving credit facility.

The risk factors identified in DBRS’s May 12, 2008, press release with respect to the May 2008 Proposal remain. Apart from the execution risk of the Transaction, DBRS recognizes the increased business risk and potentially weaker financial profiles in a weaker commodity pricing (especially for natural gas) and economic environment since the May 2008 Proposal. Other previously identified risk factors for Cenovus include the reduced economies of scale in the size and scope of its operations. While recognizing EnCana’s historic ability to manage sizable capital programs, Cenovus is expected to pursue a substantial capital expenditure program (although considerably reduced in size compared with the May 2008 Proposal), potentially resulting in reduced flexibility with respect to enhanced oil recovery oil sands properties and refining investments and a shorter reserve life for its natural gas assets compared with those of post-Transaction EnCana. These investments, as well as ongoing operations, would also reflect the escalation in industry-wide costs over the past several years, although this trend has started to reverse in recent quarters.

Offsetting aforementioned risk factors, Cenovus’s provisional ratings would be supported by its operational expertise, capital discipline, one of the lowest cost structures relative to its peers and the benefits of its consistent and active hedging programs. EnCana currently has hedges covering about half of its production for the 2010 natural gas production year at slightly over $6 per thousand cubic feet (mcf) and 27,000 barrels per day (b/d) of expected 2010 crude oil production at an average fixed price of WTI $76.89 per barrel); these hedges would be split pro rata between post-Transaction EnCana and Cenovus. EnCana also reported minimal technical pricing revisions to its proved reserves at year-end 2008, despite the sharply lower year-end commodity prices, highlighting its conservative reserve booking practices and its relatively low cost base.

DBRS expects to finalize Cenovus’s assigned provisional long-term rating if the Transaction proceeds as expected, including the following key factors:

1. Cenovus will have satisfactory operating results and cash flows, and will use free cash flow to reduce debt levels prior to the Transaction’s closing to improve its initial credit profile.

2. Legal, tax, contractual and regulatory matters will be satisfactorily resolved.

3. Initial capital structure will be satisfactory so that Cenovus will maintain its financial profile well within EnCana’s current credit metric targets.

4. DBRS’s expectation and management’s commitment that future capital investment programs, share repurchases and other related activities will be managed within the context of current target metrics and that other key financial principles such as hedging policies will remain in place.

5. Liquidity arrangements commensurate with capital growth requirements will be concluded at the Transaction’s closing.

DBRS’s review will focus on the satisfactory resolution of the issues mentioned above as well as other key items that could affect the financial and business profiles of Cenovus.

DBRS notes that the Transaction would create two entities of critical mass in terms of size and scope comparable to its peers (representing a two-thirds and one-third split in production and reserves for post-Transaction EnCana and Cenovus, respectively). Cenovus would have pro forma production of approximately 248,000 barrels of oil equivalent per day (boe/d). The combination of high-growth assets and strong cash flow generating resources should enable the management team to focus on developing the underlying resource base – the enhanced oil recovery oil sands properties in the case of Cenovus. While Cenovus’s portfolio would require relatively high capital investments over the next few years, there would be minimal exploration risk compared with conventional crude oil and gas developments. Cenovus would benefit from the joint venture with COP through the integration of its enhanced oil recovery oil sands properties and the downstream upgrading/refining operations, resulting in relatively low capital costs, currently estimated by DBRS at CAD 40,000 to CAD 50,000 per b/d of synthetic crude oil capacity, compared with the more than CAD 100,000 per b/d previously estimated for projects by its oil sands participants.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Oil and Gas Companies, which can be found on our website under Methodologies.

This is a Corporate rating.