DBRS Places Cenovus Energy Inc. Under Review with Negative Implications Following Agreement to Acquire ConocoPhillips Assets in Western Canada

DBRS Limited (DBRS) has today placed the BBB (high) Issuer Rating and the BBB (high) Senior Unsecured Debt rating of Cenovus Energy Inc. (Cenovus or the Company) Under Review with Negative Implications. This rating action follows today’s announcement that Cenovus has entered into an agreement to acquire ConocoPhillips’s Western Canadian oil and gas assets for a total consideration of $17.7 billion, which includes $14.1 billion in cash and 208 million Cenovus common shares issued to ConocoPhillips (COP).

As part of the transaction, Cenovus has also agreed in certain circumstances to make contingent payments to COP. The transaction is expected to close in the second quarter of 2017, subject to customary conditions, including receipt of necessary regulatory approvals.

The cash component of the transaction is fully financed with (1) a portion of cash on hand ($3.7 billion of cash on hand at year-end 2016), (2) available capacity on the Company’s existing $4.0 undrawn committed credit facility, (3) new $10.5 billion fully underwritten bridge financing facilities and (4) a bought-deal offering of common shares for expected gross proceeds of approximately $3.0 billion. The Company plans to divest a significant portion of its legacy conventional oil and gas assets and to complete a subsequent offering of senior debt to repay debt drawn on the bridge facilities. The bridge financing obligations, which include a $3.6 billion asset sale bridge, extend for periods ranging from 12 to 24 months. Concurrent with this transaction, Cenovus has commenced the asset disposition program, initially marketing the Alberta conventional assets at Pelican Lake and Suffield, which accounted for production of 47,600 barrels of oil equivalent per day (boe/d) in 2016.

DBRS notes the strengthening of the Company’s business risk profile as a result of the acquisition. At the same time, DBRS notes the added indebtedness increases Cenovus’s financial leverage ratios enough to cause pressure on the Company’s Issuer Rating and Senior Unsecured Debt rating. Depending on proceeds raised from asset sales (which are targeted for debt reduction), a rating downgrade is likely. However, DBRS also anticipates the Issuer Rating and Senior Unsecured Debt rating for Cenovus to remain within the BBB range.

Cenovus has agreed to acquire COP’s 50% interest in the Foster Creek Christina Lake Partnership (the FCCL Partnership), which is the jointly owned oil sands venture operated by Cenovus and the majority of COP’s Deep Basin conventional oil and gas assets in Alberta and British Columbia. In total, these assets have forecast 2017 production of approximately 298,000 boe/d. On a pro forma basis, Cenovus’s combined 2017 production (before asset dispositions) is projected to increase by 103% to 588,000 boe/d. The acquisition enables Cenovus to take full control of its best-in-class oil sands development at Foster Creek and Christina Lake and adds a second growth platform across the Deep Basin in Alberta and British Columbia that provides complementary short-cycle development opportunities. The production mix to be added from the acquisition is equivalent to Cenovus’s current production mix.

DBRS notes the acquisition adds scale and size to the Company’s oil sands and conventional oil and gas operations, as well as improving operating and capital flexibility in particular with the full ownership of the FCCL Partnership. The addition of the remaining 50% interest in high-quality long-life oil sands reserves of the FCCL Partnership also fortifies Cenovus’s long proven reserve life and reserve attributes. The added rating support from these foregoing factors is partially offset by increased exposure to lower-margin non-upgraded oil sands production and weaker vertical integration. Hence, cash flow is more sensitive to commodity price volatility, most notably changes in the heavy-light oil price differential. Hedging, at attractive price levels, could assist in mitigating this risk. In DBRS’s opinion, the overall impact on Cenovus’s business risk profile is modestly positive and supports a rating within the BBB range.

Based on DBRS’s view, the additional debt plus the use of cash on the balance sheet to fund the acquisition should result in an increase in the Company’s financial leverage ratios and have a negative impact on the credit risk profile. Proceeds from asset sales will be key in assessing the overall impact on financial leverage ratios, as should the price of the WTI oil benchmark and heavy oil. However, at the current time, Cenovus has not disclosed an estimate of proceeds targeted to be raised from asset sales. In a challenging year last year, Cenovus’s lease-adjusted debt-to-cash flow ratio was 5.0 times (x). When factoring in the Company’s large cash position, the net debt-to-cash flow ratio was 2.0x. The Company’s lease-adjusted debt-to-capital ratio last year was 37.4%, and on a net debt-to-capital ratio basis, it was 18.4%. When previously assessing Cenovus’s financial risk profile, DBRS gave considerable credit to the Company’s significant cash position, thus supporting its prior rating.

At year-end, Cenovus’s long-term debt was $6.3 billion and net of cash debt was $2.6 billion. Debt, net of cash, combined with gross proceeds from the bought-deal offering and before asset sales is estimated to initially increase by approximately $7.5 billion. With Cenovus’s intention to sell a significant portion of its conventional legacy assets, and considering that $3.6 billion of the bridge facility is dedicated to an asset sale bridge, the quantum of debt eventually added is likely to be materially less than $7.5 billion. Furthermore, based on DBRS’s base oil price forecast of USD 50/bbl WTI for this year and USD 55/bbl for 2018 and 2019, DBRS projects Cenovus producing free cash flow surpluses (cash flow less capex and dividends) that can be directed toward additional debt reduction. Over time, and assuming a WTI oil price above USD 50/bbl, DBRS expects the Company’s key credit metrics to strengthen. Nonetheless, based on DBRS’s estimates, the increase in net debt is likely proportionately much greater than the incremental cash flow contribution from the acquired assets (less cash flow foregone from asset sales) through at least 2018, thus impairing the Company’s key credit metrics below a level that is consistent with the BBB range.

DBRS also notes the impact from the acquisition on the Company’s liquidity profile is expected to be marginally negative. Even considering the Company’s plans to use a significant portion of its cash on hand to partly fund the acquisition plus a possible draw on its $4 billion credit facility, the Company should still have significant capacity available on its facility and the Company has bridge financing facilities arranged for 12 to 24 months. Furthermore, the Company has no long-term debt maturities until the final quarter of 2019. The risk to the liquidity profile, in DBRS’s view, is largely oil price-related. A significant drop in the price oil drop not only would add pressure on the financial metrics but potentially trigger free cash flow deficits that will likely need to be funded.

In DBRS’s opinion, the degree of erosion in Cenovus’s key financial metrics due to the acquisition is likely to have a modest adverse impact on the Company’s overall BBB (high) ratings. An important factor on the extent of the impact, as noted earlier, is proceeds raised from asset sales. As a result, DBRS has today placed Cenovus’s ratings Under Review with Negative Implications. However, due to the strength of the Company’s business risk profile, DBRS anticipates the Issuer Rating and long-term debt rating to remain within the BBB range. DBRS anticipates resolving the Under Review status by closing of the transaction.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The principal methodology used is Rating Companies in the Oil and Gas Industry (September 2016), which can be found on dbrs.com under Methodologies.

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