DBRS Morningstar Places Cenovus Energy Inc. Under Review–Positive Following Agreement to Combine with Husky Energy Inc.

DBRS Limited (DBRS Morningstar) placed Cenovus Energy Inc.’s (Cenovus or the Company) Issuer Rating and Senior Unsecured Debt rating of BBB (low) Under Review with Positive Implications. These rating actions follow the announcement that the Company entered into a definitive agreement whereby Cenovus and Husky Energy Inc. (Husky; rated BBB (high) Under Review with Negative Implications) will combine (the Combined Entity) in an all-stock transaction valued at approximately $23.6 billion, including debt. The Combined Entity will continue to operate as Cenovus. Under the terms of the agreement, each common shareholder of Husky will receive 0.7845 common shares of Cenovus plus 0.0651 of a Cenovus warrant with a five-year term and exercise price of $6.54 in exchange for each common share of Husky. In addition, Husky will seek approval from its preferred shareholders to exchange the Husky preferred shares for preferred shares of Cenovus with substantially the same terms and conditions. The transaction has been unanimously approved by the board of directors of both companies and is structured through a plan of arrangement. In addition, L.F. Investments S.a.r.l. and Hutchison Whampoa Europe Investments S.a.r.l., owners of approximately 70% of Husky’s common shares, have each entered into a separate irrevocable voting support agreement in favour of the transaction. Subject to applicable regulatory, court, and common shareholder approvals, the transaction is expected to close in the first quarter of 2021. The Under Review with Positive Implications status reflects DBRS Morningstar’s opinion that the Combined Entity’s overall risk profile will be stronger relative to Cenovus’s stand-alone risk profile given the material improvement in the business risk profile and a modest improvement in the financial risk profile.

The material improvement in the Combined Entity’s business risk profile (compared to Cenovus as a stand-alone entity) is underpinned by the increase in size, diversification, lower cash flow volatility, and improved capital flexibility. Relative to Cenovus, on a pro forma basis, the Combined Entity’s (1) average production (based on reported production in the first half of 2020) increases approximately 58% to approximately 747,000 barrels of oil equivalent (boe) per day; (2) total daily upgrading and refining capacity increases 167% to approximately 660,000 barrels per day (bbls/d); and (3) YE2019 proven reserves increase by 28% to 6,533 million boe. The Combined Entity’s upstream assets will include heavy oil, conventional oil, and natural gas production in Western Canada, offshore oil production in Atlantic Canada, and offshore oil and natural gas production in the Asia- Pacific. The Combined Entity’s significant downstream refining assets should provide a buffer against lower crude oil prices under normal circumstances.

Relative to stand-alone Cenovus, the Combined Entity will also have less sensitivity to Western Canadian price differentials. The Combined Entity will have total heavy oil processing capacity of 350,000 bbls/d (Cenovus stand-alone: 137,500 bbls/d), committed existing pipeline capacity of 265,000 bbls/day (Cenovus stand-alone: 135,000 bbls/d), storage capacity of 16 million bbls (Cenovus stand-alone: 10 million bbls), and access to rail capacity (100,000 bbls/d). As a result, the Combined Entity is expected to be able to process or transport the majority of its heavy-oil blend (Cenovus stand-alone :~65%). The Combined Entity will also benefit from Husky’s production in Asia-Pacific, which currently generates approximately $1.0 billion in annual free funds flow predominantly under fixed-price natural gas sales contracts.

In addition, the combination is expected to generate approximately $1.2 billion in synergies ($900 million in the first year), including $600 million in operating cost synergies and $600 million in capital cost synergies. The majority of the operating cost synergies are from workforce reductions at the Combined Entity, with the balance in the form of expected efficiency gains from the application of Cenovus’s low-cost operating strategies to Husky’s thermal projects, contract-related synergies, and IT and procurement savings. DBRS Morningstar notes that Cenovus’s operating and reserve replacement costs in F2019 were lower than those of Husky and among the lowest compared to its Canadian peers. The Combined Entity expects to be able to allocate capital more efficiently across the portfolio and reduce sustaining capital to ~$2.4 billion (versus $3.0 billion for Husky and Cenovus combined). DBRS Morningstar views most of the savings from operating cost synergies as fairly straightforward to achieve though there is modest execution risk associated with achieving the capital cost synergies. The factors tempering the business risk profile include the Combined Entity’s high percentage of pro forma production from Western Canada, a reserve base geared more toward heavy and thermal oil (89% of total pro forma proved reserves at YE2019), and environmental cost pressures.

DBRS Morningstar expects the Combined Entity’s financial risk profile over the forecast period to 2022 to be modestly stronger relative to Cenovus’s stand-alone financial risk profile despite the increase in total debt (pro forma lease-adjusted debt at June 30, 2020: $17.6 billion). The improvement is a result of the combination of Husky’s stronger financial risk profile and expected synergies from the combination. Despite generating material free cash flow (FCF; cash flow after capital expenditures (capex) and dividends) deficits in H1 2020, Husky’s gross debt levels remained relatively unchanged at June 30, 2020, compared to YE2019 because of the use of its large cash balance to fund its FCF deficit. However, in the absence of material cash balances, FCF deficits at Cenovus have led to a material increase in total debt over the same period. Husky’s financial risk profile is also supported by its fixed-price natural gas sales contracts in Asia-Pacific as noted earlier.

Based on DBRS Morningstar’s price forecasts, the Combined Entity is expected to generate a modest FCF surplus (excluding one-time transaction-related expenses) in 2021. DBRS Morningstar expects the FCF surplus to improve materially in 2022 as the Combined Entity benefits from expectations for higher commodity prices, lower cost structure, capital cost efficiencies, and modest dividend payments. Cenovus and Husky were quick to react after the decline in crude oil prices earlier this year with Cenovus suspending its dividend payments and Husky reducing its dividend by 90%. In addition, both companies reduced their combined capex by ~$2.5 billion.

Cenovus and Husky, in the current low price environment, have committed to reducing financial leverage and DBRS Morningstar expects the Combined Entity to continue to prioritize deleveraging the balance sheet with expected FCF surplus in 2022. DBRS Morningstar expects key credit metrics under its base-case commodity price assumptions to remain weak in 2021 before improving in 2022 (lease-adjusted debt-to-cash flow at or around 2.50 times) as earnings and operating cash flow increase because of assumptions for higher commodity prices in 2022 and the FCF surplus targeted to further reduce debt. Given the operating cost and capital cost synergies and strong downstream presence, DBRS Morningstar expects the Combined Entity to be able to deleverage meaningfully over the medium term even in a West Texas Intermediate (WTI) price environment of USD 45 per barrel. The Combined Entity expects a FCF WTI breakeven price of USD 36 per bbl in 2021, which is expected to reduce further to USD 33 per bbl in 2023.

The Combined Entity is expected to have strong liquidity at close with committed credit facilities of $8.5 billion, which are expected to be undrawn. The credit facilities have maturity dates varying from June 2022 to March 2024. The Combined Entity’s debt maturities are well spread out with medium-term maturities of USD 1.0 billion due in 2022, USD 450 million due in 2023, and USD 750 million due in 2024. DBRS Morningstar also notes that the Combined Entity

remains committed to pursuing environmental, social, and governance (ESG) targets with an ambition of achieving net zero carbon emissions by 2050.

DBRS Morningstar expects to resolve the Under Review with Positive Implications status by the close of the transaction. Assuming the transaction closes as described in the plan of arrangement and based on DBRS Morningstar’s assumptions, the ratings of Cenovus by close is likely to be one notch higher than its current ratings. DBRS Morningstar notes that the resurgence of the Coronavirus Disease (COVID-19) has injected volatility into the outlook for crude oil demand and commodity prices. Deteriorating market conditions and/or a downward revision to DBRS Morningstar’s base-case commodity price assumptions could have a negative impact on the ratings.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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

The principal methodologies are Rating Companies in the Oil and Gas and Oilfield Services Industries (August 17, 2020) and DBRS Morningstar Criteria: Rating Corporate Holding Companies and Parent/Subsidiary Rating Relationships (November 25, 2019), which can be found on dbrsmorningstar.com under Methodologies & Criteria.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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 under Related Documents or by contacting us at info@dbrsmorningstar.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

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