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Cenovus goes big

Can the Deep Basin help Cenovus make a success of its ConocoPhillips deal?

Canada's Cenovus Energy is primarily known as the country's largest thermal oil sands players, operating some 360,000 barrels per day of steamed, tarry bitumen output in northeastern Alberta.

But with its blockbuster C$17.7bn ($13.19bn) buyout of much of ConocoPhillips' Canadian business, the industry's biggest M&A deal since Shell bought BG, it has suddenly become the country's third-largest unconventional gas producer. In addition to the 50% stake in the Foster Creek Christina Lake (FCCL) oil sands project, Cenovus acquired nearly 3m acres of unconventional shale and tight gas acreage in a region known as the Deep Basin, which straddles the northern Alberta and British Columbia borders.

For Cenovus' shareholders, though, bigger wasn't necessarily better. Shares fell to multi-year lows when the deal was announced in April over worries about the huge volume of debt the company must take on to finance the purchase. As a result, its gearing ratio jumped from 18% to 40%. But, analysts and insiders say, the Deep Basin was key to the success of the transaction and its long-term value may be being overlooked in the rush to judge the deal.

 

The Deep Basin has been drilled extensively for years, but advances in hydraulic fracturing technology are transforming the play. It has the potential to become among the most prolific shale plays in North America, rivalling the Marcellus in Pennsylvania and the Permian in Texas.

While a wave of oil sands assets have hit the market, as majors such as Shell, Total, Statoil and Chevron run for the exits, Deep Basin deals of this magnitude don't come around often.

"There was still some growth potential with those (oil sands) assets but it was a non-operated position and we'd already decided to sell some of our Deep Basin gas assets in Canada," ConocoPhillips' chief executive Ryan Lance told Petroleum Economist. "They had an interest in both the gas assets in the Deep Basin and taking over all 100% of their operated FCCL interest."

ConocoPhillips was producing approximately 120,000 barrels of oil equivalent per day in the Deep Basin—in addition to the 180,000 b/d it shared in the FCCL project at the time of the sale. But it hadn't pumped a lot of capital into the acreage as it shifted focus to more lucrative US shale plays. Low natural gas prices and uncertainty around plans to export liquefied natural gas from the British Columbia coast put the Deep Basin project on the backburner for ConocoPhillips.

Power play

Cenovus took a different view. Its growing oil sands operations consume a vast amount of both gas and natural gas liquids to generate steam and power. The Deep Basin production provided an opportunity to vertically integrate its supply chain and to lower input costs at its thermal bitumen projects, while holding out significant upside (if and when gas prices recover).

Cenovus says it plans to increase output from the acquired Deep Basin fields by around 40%, to 170,000 boe/d by 2019. An analysis by consultancy Wood Mackenzie suggests that with a more ambitious drilling programme it could nearly quadruple output on those lands to 350,000 boe/d by 2021, though it would need higher gas prices and reduced drilling costs to pull that off.

Cenovus will target a virtually untapped formation called the Spirit River that underlies most of the ConocoPhillips lands. Wood Mackenzie estimates that the Spirit River formations could hold 700m boe, and the company says it has lined up around 700 drilling targets already.

If Cenovus can indeed quadruple output from its Deep Basin gas acreage, it will be in a strong position to supply new LNG export plants, if they're built. It's a speculative bet, but a compelling one.

It also represents a significant reversal in thinking for the Canadian stalwart. Cenovus was spun out of Encana in 2009, when investment bank analysts were pressing large complex oil and gas companies to simplify, precisely to become a pure play oil sands producer. Encana took more than 90% of the company's gas in the split to become a pure-play gas producer.

Both are now rediscovering the virtues of diversification. Encana has abandoned its once blinkered gas focus by taking significant positions in US Permian light oil. And through this deal, Cenovus is reducing its exposure to the battered Western Canada Select oil price benchmark with a big bet on British Columbia gas.

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