ANALYSIS: Former hunter Husky Energy now prey in Cenovus deal to bolster refining capacity

New York — Husky Energy, once the hunter in a bid to find crude derived from Canadian oil sands for its refineries, has become the prey after producer Cenovus Energy unveiled plans on Oct. 25 to buy the company in an all-stock transaction valued at C$23.6 billion.

Cenovus, which steams tar-like bitumen out of sand in remote regions of northeastern Alberta, will tie its 475,000 b/d of production with Husky's 410,000 b/d of refining ability to achieve near balance in crude output with refined product sales.

The deal will make Cenovus the second-largest Canadian-based refiner and third-largest oil producer, with approximately 750,000 b/d of output tied to 660,000 b/d of refining capability.

Houston-based ConocoPhillips owns 17% of Cenovus, a holding that will fall to about 10% after the deal, company officials said.

Cenovus CEO Alexander Pourbaix will retain his position in the new company, while CFO Jonathan McKenzie will be COO of the combined entity. McKenzie jumped to Cenovus from Husky in 2018, where he was also CFO.

"McKenzie will be COO, which makes sense given he has intimate knowledge of Husky's assets and people [i.e., he would know of any skeletons in the closet]," Phil Skolnick, an analyst with Eight Capital in New York, said in an Oct. 26 note. "As such, the transaction was likely well thought out and not motivated by a rush to be relevant. Furthermore, this not only gives us confidence in the C$1.2 billion of expected synergies, but that there is upside to that number."

Canadian oil sands companies face limited markets for their product, which requires complex refineries to process the heavy oil into fuels, and perennial shortages of pipeline capacity to get their crude to market. Cenovus has faced problems with both, relying on about 250,000 b/d of refining capacity in the US it owns through a venture with Phillips 66 and scrambling to find transportation for its crude, including building a large rail loading terminal to send it to refineries by train.

Transportation woes

Husky tried a similar deal under vastly different economic circumstances with a failed bid for Cenovus rival MEG Energy Corp. in 2018. Husky launched its bid for MEG amid a severe pipeline capacity crunch that led to fire-sale pricing for bottlenecked Western Canadian crude.

The company's plan was to use its large holdings of contracted pipelines to move oil sands-derived crude to its refineries in Ohio to take advantage of the wide spread between bitumen prices and refined products. In the last year, that advantage had evaporated as Canadian producers cut output, leading post-pandemic prices for benchmark Western Canadian Select to rebound faster than motor and jet fuel demand.

The companies estimate the combined entity will make money at benchmark West Texas Intermediate Crude prices of US$36/b in 2021 and US$33/b by 2023. Husky's lower debt levels compared with industry metrics will help Cenovus, which has struggled to retain credit ratings after its acquisition of ConocoPhillips' stake in its oil sands projects and other Canadian holdings for almost C$17 billion in 2017. The combined company's synergies are estimated to lower net-debt-to-adjusted-EBITDA, a key credit metric, to less than 2x by the end of 2022.

"In a market where upstream and downstream fundamentals remain under siege and COVID is again surging, this deal is consistent with the pre-COVID consolidation trends that are much more logical now with so much volatility all along the value chain," analysts at CreditSights said in an Oct. 26 note. "For Cenovus, the action now actually makes them a true integrated oil and gas operator in line with their US high-yield index designation with the merger of a downstream-heavy and oil sands-dependent Cenovus and the infrastructure-rich Husky."

Husky and Cenovus had separately committed to achieving net-zero emissions by 2050, a goal that the combined company will continue to pursue. Canada's energy companies have been under pressure to improve environmental performance as some investors and insurers have scaled back their involvement in the sector.

Who's next?

Officials of both companies did not speculate on the future of Husky's offshore assets, which could generate funds for the transaction should they be sold.

Husky has already shelved work on its West White Rose project off the shore of Newfoundland and Labrador, and is a partner and operator in other projects off Canada's east coast. It also operates offshore gas and oil fields in Asia. Cenovus has kept its operations mostly confined to Alberta with a focus on oil sands production, with the exception of its refineries in Texas and Illinois. It also has gas holdings in the shale regions that straddle the Alberta-British Columbia border.

With the Cenovus-Husky tie-up underway, speculation has begun about which Canadian company will be next in line for a merger.

A lower-for-longer oil price scenario, along with lingering demand impacts from COVID-19, has launched a wave of combinations in the US, and Canada is expected to follow the trend. MEG Energy, the former Husky target, is the last of the mid-sized, production-only oil sands companies left. MEG Energy has weathered the pandemic better than many of its peers, possibly because of the large shareholding of China government-backed China National Offshore Oil Corp. The company also steadfastly refused Husky's 2018 offer at C$11/share. MEG Energy stock traded at C$2.34/share in late trading Oct. 26 on the Toronto Stock Exchange.

"This is likely just the start of big deals in Canadian energy land, and thus it begs the question of who is next?," Eight Capital's Skolnick said. " As seen in the US with the accelerated M&A activity, when there's one meaningful transaction, there's likely more to come."