(Idea) Cenovus's Selloff Is A Buying Opportunity
(Idea) Cenovus's Selloff Is A Buying Opportunity
Note: Dollar references are to Canadian dollars unless otherwise specified.
Cenovus Energy’s (CVE) abysmal performance has left a lot of investors scratching their heads. So far this year, the shares have broken below their 52-week high to levels last seen two years ago. The price action begs the question of what’s going wrong.
The chart below plots the relative six-month performance of CVE versus the oil sands majors Suncor Energy (SU) and Canadian Natural Resources (CNQ), as well as the Canadian E&P ETF XEG (XEG:CA) and WTI. It shows that CVE began to underperform in late October when WTI started a sustained decline. The stock's downward move accelerated over the past few weeks, even though WTI has traded sideways.
The most obvious cause of CVE’s selloff is lower oil prices. Low prices coupled with flat production translate into significantly less free cash flow. Of course, less free cash flow translates into a lower share price.
CVE has also fallen out of favor as the fundamental oil market outlook deteriorated over the past few months. After a disappointing fourth quarter, where an expected large inventory draws turned out to be modest draws, the consensus outlook for 2024 calls for a broadly balanced market and sub-US$80 WTI over the next several quarters—a hot war in the Middle East be damned. The outlook is causing investors to question the rationale for holding any E&P stock, let alone CVE.
Investors Lose Confidence
All E&Ps have sold off due to the fall in oil prices, so CVE’s underperformance—which is a recent phenomenon—also reflects a loss of confidence among investors in the company’s long-term fundamental prospects.
The first cause of this loss of confidence stems from management’s overpromising and under-delivering in communicating when CVE will achieve its $4 billion net debt target, at which point it will deliver 100% of free cash flow to shareholders through dividends and share repurchases.
Clearly, management erred in guiding to enhanced capital payouts to shareholders. It understands CVE’s financials better than anybody, and it should have appreciated that capital return prospects hinge on commodity price performance. By failing to do so, management set investors up for disappointment when commodity prices fell and the time required to hit the debt target was pushed back.
Management’s error damaged its credibility with investors, many of whom owned the stock for the prospect of increased dividends and share repurchases. The error also calls into question the accuracy of management’s estimates of other variables.
The second cause of reduced confidence is CVE’s poor fourth-quarter earnings outlook, which emerged among analysts over recent weeks. Before that, investor hopes were running high after CVE posted a $3.4 billion corporate netback in the third quarter and generated free cash flow of $1.22 per share, or $4.88 on an annualized basis. However, analysts now expect earnings to be weaker than initially expected owing to lower oil prices and thin refining margins.
Weaker earnings in the fourth quarter will be mostly attributable to WTI’s 22.5% decline from US$90.79 to US$74.11 per barrel and a lower average WTI price than the previous quarter. At the same time, refining margins hovered around the low levels seen in the second quarter of 2023, when CVE reported poor downstream earnings, though the second-quarter underperformance was also related to low utilization in the company's U.S. refineries. Refining margins are shown below, with the fourth quarter circled in red.
Source: Barchart.com. Red line added by author.
With an earnings disappointment looming on the horizon, investors are reluctant to buy CVE shares due to the risk of a further selloff after fourth-quarter earnings are released.