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Free cash flow analysis for Encana [ClearOnMoney]
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Free cash flow analysis for Encana

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Commentary

Free cash flow analysis for Encana

19 Jan 2012 by Jim Fickett.

It is challenging to apply a free cash flow analysis in a highly cyclical and capital intensive sector. With one very rough approximation to deal with the challenges, we find that, had Encana limited itself to just replacing rather than expanding reserves, it would have provided a cash return of about 2.3% in 2010, even with the very low gas price. This suggests the current, highly depressed stock price is a bargain.

Recall that free cash flow is cash from operations less capital expenditures. Here are the basic figures for Encana, for the last few years, in millions of US dollars:

Year Cash from operations Capital expenditures Free cash flow Gas price
2008 6224 -5255 969 $7.99
2009 5041 -3755 1286 $3.73
2010 2365 -4773 -2408 $4.47
2011 1928 -4461 -2533 $4.33

Figures are taken from annual and quarterly reports on the company web site. 2011 results are scaled up from the first three quarters. Since Encana was split in half in 2009, with oil assets going to a new company Cenovus, and the new Encana keeping most of the natural gas assets, results for 2008 and 2009 are pro forma, to include only the assets and operations that form the current company. The gas price listed is the average market price received by Encana in the year named; it does not include any hedging returns.

Free cash flow in 2010 and 2011 was negative. This is not surprising, given the current very low gas price. As I've written many times, most companies are losing money producing gas at recent prices. In fact, what the industry as a whole is spending just to maintain current production levels is almost twice what they are getting from selling the gas:

Research by energy economist Peter Tertzakian shows just how economically strained natural gas exploration and development has become in the past few years, as the boom in high-tech shale-gas drilling has both massively swelled North American production rates and greatly increased costs.

He noted that shale wells not only cost “three to four times” as much to develop as conventional gas wells, their rate of depletion – the amount production declines over time, a natural phenomenon with all wells – is much higher. As a result, the average annual depletion rate across the industry has risen from about 23 per cent five years ago to more than 32 per cent now.

That, combined with the 20-per-cent surge in North American gas production in the past five years, (which makes for more and more depletions to replace each year), has meant it now costs the industry about $22-billion each quarter just to replace the annual depletions and maintain current volume levels. Yet those producers are seeing only about $12-billion a quarter in cash flow, he said.

“The resulting capital gap is now on the order of $10-billion a quarter, or a phenomenal $40-billion a year,” he said.

One of the reasons I like Encana is that their costs are lower than those of most companies, due to a long history of buying good land early and developing more efficient methods for production. In a recent presentation they claim that they can make a 9% internal rate of return with gas in the $4-$5 dollar range, while for other companies this requires gas prices up to two dollars higher.

OK, so Encana claims it can make money when gas prices are above $4 yet, in 2010, when the price averaged (for them) $4.47, they had significantly negative cash flow. What happened? When the new Encana was launched in 2009 they announced that they would rapidly double gas production per share, and they set about a very ambitious exploration and development program, which required high capital spending.

This is what makes a free cash flow analysis so challenging in a capital-intensive sector like oil and gas. Capital expenditures are uneven year to year, and they do not pay off immediately, so in order to get a meaningful idea of cash flow, you really need several years of results, preferably with the company holding to a constant strategy. In the case of Encana, not even the company itself is a constant.

As a very rough approximate, we can assume (as is often done in this sector) that capital spending is proportional to reserve additions. This will allow us to get some idea of the cash flow under steady-state conditions.

In 2010 Encana produced 1.2 trillion cubic feet of gas (Tcfe), but added 3.1 Tcfe to reserves, 1.9 Tcfe more than needed to replace what was produced and sold. If we scale back capital expenditures to what would have been necessary just to replace volumes produced, we get

free cash flow under steady-state assumption = 2365 - (1.2/3.1)*4773 = $517m

In other words, if Encana had been content to just replace reserves instead of expanding their reserve base, their free cash flow might have been about $500m. At the end of 2010 the market cap was $29/share * 736 million shares = $21.3bn, so $500 million would have provided about a 2.3% cash return. That is not a bad return at all in an environment of very low interest rates and very low gas prices, and suggests that the currently depressed stock price, of $17.50, is a bargain.

I do not place a great deal of weight on this calculation, because it is very hard to know what level of capital expenditure is really necessary, in any given year, in order to maintain the company in a steady state. Still, it adds some weight to the argument that Encana has, for several years, invested enough capital to expand significantly, rather than just maintain the status quo (the big drop in 2009 was due, of course, to splitting off Cenovus):

I.e. this is a trend, not a one-off, so scaling back capital expenditures is more likely to be meaningful.

To sum up, (1) capital expenditures are high due to ongoing expansion, and are adding real value to the company, so (2) negative cash flows, particularly in a context of very low gas prices, are not worrisome, and (3) a rough best guess for what free cash flow in a steady state would look like suggests that the current stock price is far too low.