DBRS Confirms Cenovus Ratings at A (low) and R-1 (low)

DBRS has today confirmed the ratings of Cenovus Energy Inc.’s (Cenovus or the Company) Senior Unsecured Debt at A (low) and its Commercial Paper at R-1 (low), reflective of the Company’s consistent performance since its spin-off from Encana Corporation (Encana) on November 30, 2009. The underpinnings were increased oil sands volumes and improved margins in the downstream operations (Downstream). At March 31, 2011, both debt-to-capital and debt-to-EBITDA (30% and 1.25 times (x)) were at the lower end of Cenovus’s targeted ranges of 30% to 40% and 1x to 2x, respectively. DBRS also expects debt-to-cash flow to be within 1x to 2x (1.57x in the last 12 months ended March 31, 2011 (LTM)). (Operating results for the six months ended June 30, 2011 (H1 2011) are in line with expectations with these credit metrics improved further to 28%, 1.11x and 1.26x, respectively.) Consistent active hedging should ensure certain cash flow stability for the Company’s substantial growth path. Considerable growth opportunities exist through oil sands developments supplemented by conventional crude oil activities in the near to medium term.

However, the recently announced accelerated growth plans to more than double oil production (gross) to about 500,000 b/d over the next decade (about 14% CAGR) underpinned by about a six-fold increase in oil sands volumes could pressure the balance sheet and Cenovus’s operational capability.

Cost overruns and project delays are potential concerns, despite the more scalable nature of Cenovus’s in-situ versus mining projects. Operating cost per barrel (up 40% to $9.75/b from 2007 to 2010) could also increase as the Company plans to launch a new development phase every 12 to 18 months. Beyond 2011, cash flow shortfalls could result, given the projected annual capex of $3.0 billion to $3.5 billion ($2.3 billion operating cash flow for LTM) to 2021. External funding will likely be required, should WTI fall below $80/b and Nymex below $4/mcf. Furthermore, the Company intends to raise its current dividends after 2011. Any substantial increases would add to cash flow shortfalls, although partly mitigated by planned divestitures of $300 million to $500 million (about $300 million in 2010). Capex for 2011 (average of $2.5 billion versus $2.2 billion in 2010) is about 80% of projected cash flow (near 90% in 2010) based on the Company’s revised July 2011 guidance (WTI at $97/b and Nymex at $4.40/mcf) helped by the robust crude oil prices and strong refining margins. About 40% of the Company’s output is in heavy crude oil (including oil sands) and is affected by the recent widening in light/heavy crude oil differentials (Differentials) and third-party pipeline disruptions. These factors also negatively impacted netbacks in Q1 2011, although improvements are expected, over time.

DBRS expects the Company to balance aggressive growth with financial discipline and operational prudence in order to maintain its current ratings. The Company retains sufficient liquidity through a $2.5 billion three-year revolving credit facility to 2014 ($2.25 billion available at March 31, 2011), with no material debt maturities until 2014. Sustaining capex anticipated at around the $1.0 billion level, when the Downstream upgrading project is complete (scheduled by late 2011), should provide more capital flexibility to Cenovus. The project will increase refining capacity to handle Canadian heavy oil (estimated cost of about $1.95 billion net to Cenovus mostly spent), enhancing Cenovus’s value chain and overall returns.

The Company maintains operational expertise, capital discipline and one of the lowest capital cost structures in terms of finding and development cost (F&D - $7.76/boe three-year average) relative to its peers. Further, capital costs are more scalable and manageable than for large scale mining projects (estimated at $22,000 to $28,000 for Upstream versus over $100,000 for mining including upgrading facilities), helped by the integrated nature of the operations through the joint venture (JV) arrangements with ConocoPhillips (COP). Phased developments in the 30,000 b/d to 40,000 b/d range are economical as seen in Foster Creek (FC) and Christina Lake (CL), the two producing oil sands projects for Cenovus. There is minimal exploration risk in its oil sands developments. In addition, strong cash flow generating resources, emanating from mature conventional oil and gas assets in western Canada (primarily in Alberta and Saskatchewan), and the substantially improved Downstream cash flow at least in the near term, should augment the high-growth oil sands operations. The latter will likely not be self-funding for some time. The Company also benefits from its consistent and active hedging programs, covering about 55%/25% of its expected 2011/2012 production (with gas hedges at above market prices and oil hedges below market).

There are limiting factors, apart from the substantial capital investments planned to 2021, although these are considerable manageable. A 5% (average) production decline is projected in 2011 attributable to natural field declines and planned natural gas asset divestitures. Over time, the Company is expected to be more heavily oil-weighted (52% in Q1 2011), exposing it to volatile oil price movements versus its currently balanced product mix. However, the continued weak natural gas prices have negatively affected the Company’s operating results in the last 18 months.

As an aside, COP’s recently announced proposed spin-off of its downstream operations should not have any material rating impact on Cenovus (see press release of July 14, 2011). The JV includes FC and CL in-situ oil sands operations (about 25% of current production) and two refineries (Wood River, Illinois, and Borger, Texas) in the United States. Cenovus’s other oil sands projects include wholly owned Grand Rapids with regulatory filing expected in Q4 2011 and other leases. It also owns and operates crude developments at Pelican Lake, in Saskatchewan and Southern Alberta as well as shallow gas in Alberta.

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

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