Cenovus Energy: Energy Crisis Could Mean Huge Profits (CVE)

Cenovus Energy (NYSE:CVE)(TSX:CVE:CA) is one of Canada’s best performing energy stocks in 2022. Up 57% for the year, it has massively outperformed the Toronto Stock Exchange (“TSX”) energy index. If you’d invested $10,000 in CVE at the start of the year, you’d already be at $15,700. If you’d invested that sum at the 2020 low ($2.35), you’d be sitting pretty with $108,200. Amazingly, these gains could potentially continue.

The thing you need to keep in mind about Cenovus is that despite its massive year-to-date gains, the stock is actually down from the June highs. Today, the stock trades for $19.87. At the peak, it traded for $25. So we’ve seen the price come down about 20%.

This may represent a buying opportunity. When WTI Crude Prices were at $120, the markets valued Cenovus more richly than they do today. Oil prices fell from that lofty high, but they’ve been rising again lately, having gained about 6.5% in the last week.

Past results don’t predict future results, but the futures market may have good reasons for bidding up oil. The U.S. strategic petroleum reserve (“SPR”) is currently draining 1 million barrels per day; the reserve started the year at 594 million barrels and has been draining since the start of April. That’s 5 months of 1 million barrels per day being sold, so the reserve is likely now at about 444 million barrels. That’s a little more than a year’s worth of reserves.

Obviously this can’t go on forever. It could theoretically go on for another year or so, but that would leave the U.S. without an emergency supply of oil. Most likely the reserve release will end this year. It’s currently scheduled to end in October, recently the International Energy Agency (“IEA”) said that it could consider more releases, but that would just be kicking the can down the road. Eventually the SPR will run out of oil.

Additionally, the IEA is an international body (other countries are doing reserve releases, not just the U.S.), and it doesn’t have binding authority over governments. Countries wary of depleting their emergency supplies may follow the U.S.’s example and end their releases in October.

All of this is bullish for oil prices, and for Cenovus Energy stock. In its most recent quarter, Cenovus delivered $19.1 billion in revenue, up 80%, and $1.19 in EPS, up 981%. It was phenomenal growth. If oil prices pick up in September, then the next quarterly earnings release could deliver similar growth. Additionally, CVE is reducing its debt every quarter, which paves the way for earnings growth even if oil prices stay flat. Taking all of these factors together, we can see that there’s a lot of potential for CVE stock to rise in the future.

Cenovus Energy – The Business at a Glance

Cenovus Energy is an integrated energy company. Its business activities include:

• Extracting crude oil and natural gas.

• Selling crude oil to refiners.

• Refining its own crude oil.

• Selling gasoline at Husky Energy gas stations.

• Selling crude oil to end users in the United States and elsewhere.

• Selling other miscellaneous compounds like Ethanol.

This is a pretty typical mix of business for an integrated energy company. What makes Cenovus stand out is its commitment to growth. In a year when many people are complaining that oil companies aren’t investing enough in production, Cenovus has announced two big deals: buying 50% of a Toledo refinery, and 50% of the Sunrise oil Field – in both cases from BP (BP). BP is selling the assets cheap, so Cenovus may reap profits from them in the future.

These cheap acquisitions may give Cenovus an edge over competitors. When you buy assets cheap, you typically enjoy higher margins than your competitors. Cenovus is already experiencing dramatic earnings growth this year with its 50% stakes in Toledo and Sunrise, it could experience a big jump when it owns them outright. Another competitive advantage Cenovus has is its breakeven oil price. Below $45, it’s competitive with other Canadian oil companies.

Financials and Valuation

Cenovus Energy is showing incredible financial strength this year across all of its business segments. In its most recent quarter, it delivered:

• $2.9 billion in cash from operations, up 118%.

• $3 billion in adjusted funds flow, up 71%.

• $7.5 billion in net debt, down 39%.

• $2.2 billion in free funds flow, up 77%.

• $2.4 billion in net income, up 981%.

Pretty strong results overall. The bottom line growth was phenomenal (nearly 1000%!) and the cash flow metrics were good too. A quick glance at Seeking Alpha Quant shows that it’s the same story with the long term averages. Over the last five years, CVE has grown at the following CAGR growth rates:

• Revenue: 35%.

• EBIT: 77%.

• Normalized net income: 68%.

• EBITDA: 38%.

Oil prices didn’t even start getting really hot until this year, yet the five year compounded growth rates are very good. On top of that, we have an ever-shrinking debt load, which can pave the way for higher profits even if oil prices don’t budge.

Now, let’s take a quick look at CVE’s balance sheet. As of the most recent quarter, key metrics included:

• $43.4 billion in assets.

• $23 billion in liabilities.

• $20 billion in equity.

• $11.9 billion in current assets.

• $6.8 billion in current liabilities.

• $8 billion in long term debt.

From these metrics we can calculate a 0.4 debt-to-equity ratio, suggesting high solvency, and a 1.75 current ratio, suggesting high liquidity.

Valuation

Given all of CVE’s explosive growth, you would think it would be a pretty expensive stock. High growth usually commands a premium, and CVE has growth in spades. However, when we look at the multiples, we can see that CVE isn’t very expensive at all. Based on today’s stock price and TTM earnings, CVE trades at:

• 12.2 times earnings.

• 0.64 times sales.

• 1.9 times book value.

• 5.5 times operating cash flow.

All very cheap multiples. Additionally, in a discounted cash flow model assuming 10% annual growth over 5 years, followed by 0% growth thereafter, and using an 8% discount rate, we get a fair value estimate of $41.20, a little more than double the current stock price. So, both multiples and a fairly conservative DCF model suggest that CVE is undervalued.

Risks and Challenges

As we’ve seen, CVE stock is cheap, is growing its earnings and is paying off its debt rapidly. As long as oil prices just stay flat, it’s a good value. If oil prices rise, it’s a great value. However, there are many risks and challenges to be aware of, many of them pertaining to the price of oil:

• Continued SPR releases. In the introduction to this article I wrote that the U.S. SPR release is scheduled to end in October. That’s true as of the most recent reports, but things could change in the future. The SPR has enough oil to keep draining at one million barrels a day for a year and three months. If the U.S. did that, it would slow down CVE’s gains considerably, delaying price appreciation until well into the future.

• Interest rate hikes. The Federal Reserve still seems pretty committed to aggressively hiking interest rates. Last week, Fed Chair Jerome Powell went to Jackson Hole to pledge his commitment to raising interest rates. Later, Neel Kashkari took to Twitter (TWTR) to say he was happy about the market’s reaction to Powell’s speech that day (the markets crashed). This does not look like a Fed that’s ready to back down on taming inflation. The higher the price of oil goes, the more likely it becomes that the Fed will do a jumbo rate hike to get it back down again.

• ESG issues. It has been suggested that BP sold its valuable assets to Cenovus for next to nothing because of ESG concerns. Basically, oil refineries and other oil assets create emissions, which can result in damage to the environment. The ESG risk to oil companies can be overstated – it hasn’t stopped them from producing record profits this year – but it is real. BP racked up nearly $6 billion in lawsuit settlements and fines after its 2010 oil spill. This is the same company that sold the Toledo refinery to Cenovus for peanuts. Perhaps BP’s long history of environmental lawsuits makes it overly sensitive to ESG concerns, but on the other hand, maybe it knows about real risks associated with operating the refinery. Only time will tell.

The Bottom Line

The bottom line about Cenovus Energy is that it’s a dirt cheap oil company with sky-high growth that will grow larger still if oil prices continue to rise. Even if oil prices stay flat, it could produce modest earnings growth, thanks to its debt reduction. On top of that, it recently acquired some extremely valuable assets from BP for pennies on the dollar. This stock definitely looks like a winner, and I’d probably hold it if I weren’t already fully invested in other things.