Hunker down, happy hour is over
October 16, 2008
Back in the summer, Randy Eresman, the meticulous engineer who runs the country's largest energy company, sat down in a brown leather chair and talked about how Breaking Up is Hard to Do. EnCana Corp.'s executive group was drawing two lists - who would stay, and who would go to the new oil spinoff. And it was tough.
"It's going to be a sad day when we actually end up splitting and moving people apart that have worked together for a very long period of time," he said.
EnCana's 15-person board already divides into two groups at meetings: one for oil, one for gas. The company has spent millions on advice from lawyers and accountants and figuring out a new IT system for the oil entity, to be called Cenovus Energy. It has been recruiting new employees and deciding on office space.
All told, the restructuring is expected to cost up to $300-million (U.S.) - but could potentially add billions in shareholder wealth, if it succeeds in removing a hefty discount from EnCana's shares.
The investment logic was inescapable. What could possibly derail it?
The biggest financial crisis in 75 years, that's what. EnCana yesterday made it official: its plan is now on hold until the markets take a Valium or five. Or, better yet, some Zoloft. No one knows when that will be and EnCana has refused to give a timetable for the split, which had been scheduled to happen in January.
For the rest of the oil patch, the message couldn't be clearer. In boomtown, happy hour is over. Growth has given way to self-preservation.
It's all about capital now: who's got it, who doesn't, how to get more of it. EnCana's oil sands play needs a lot of it; this year, that division will be getting $1.2-billion in investment. Cenovus was meant to own some of EnCana's mature, conventional gas wells and use their cash flow to help fund the expansion of its projects in Athabasca.
The theory worked better when natural gas prices were $11 (U.S.) per mcf, as they when Mr. Eresman announced the breakup proposal in May, rather than $6.50, as they are today. The bigger issue is the potential cost of borrowing. Like every other company in the world, EnCana's caught in the vise of the credit crunch. Two months ago, the company's 2017 bonds were yielding about 200 basis points more than comparable Canadian government bonds (that is, an investor could expect an annual return of 2 percentage points more, if they bought the bond and held it to maturity). Now it's about 400 basis points. Any new loans, of course, would be that much more expensive. So better to just wait, to hunker down inside the safety of a bigger company.
EnCana is solidly investment grade, rated A-minus by Standard & Poor's. It has excellent assets. If it's getting screwed in the loan market, what does that say about the rest of Big Oil? What's required is nothing less than a major rethink of all the billions being thrown around in Fort McMurray and elsewhere.
Take Petro-Canada, where spending had grown like Topsy. Three years ago, the people's oil company spent $3.5-billion (Canadian) in capital expenditures; this year's plan called for $5.3-billion. Some of that has been driven by the Fort Hills oil sands project, where the latest cost estimates - no doubt already out of date - have ballooned to some $24-billion.
Forget about the numbers, though. Maybe Fort Hills will be a great project and maybe it won't. Maybe Petrocan's big gas project in Syria is terrific and maybe it isn't. The question for all these companies is, compared with what? If Petrocan can still earn a 12- or 14-per-cent return on the capital it's plowing into Fort Hills, well, that's nice. But if its own shares are 25 or 30 or 40 per cent undervalued, it's insane - especially if capital is getting more expensive - not to instead spend the money buying them back.
You could insert the name Nexen Inc. or EnCana or Talisman Energy Inc. and the argument remains the same. All of these, at times, have been considered good breakup candidates. All, in theory, are worth more in pieces than as a whole, and the gap is getting wider as the Massacre of 2008 goes on and on. One analyst we know swears that - at modestly higher oil prices - Nexen is easily worth $40 or $45 a share. Yesterday it closed at $14.80. Talisman hasn't been this low since the beginning of 2005 - when oil was $43, not $75.
This is the coda to EnCana's decision. As long as it delays the breakup plan, it forestalls a tax hit of about $1-billion, according to Peters & Co. analyst Kam Sandhar, who also expects the company to scale back next year's capital spending by $1-billion, compared with what the two independent firms would have spent. The money will come in handy.
The other big oil CEOs now face a choice, you see. They can use ever-pricier capital to pursue ever-riskier expansion ideas.
Or they can make do with what they've got and find oil where it's cheapest - on their own balance sheet. It's really no choice at all.
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