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The most persuasive argument that Encana is undervalued is based on reserves [ClearOnMoney]
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The most persuasive argument that Encana is undervalued is based on reserves

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Commentary

The most persuasive argument that Encana is undervalued is based on reserves

22 Jan 2012 by Jim Fickett.

The current market price for Encana implies that the company will do no better than recover sunk capital on current proved reserves, and places a value of zero on all further gas resources.

One standard valuation measure for upstream oil and gas companies is enterprise value divided by reserves, measured in dollars per barrel for oil or dollars per thousand cubic feet (mcf) for gas.

Enterprise value is market capitalization, plus debt, less cash; in other words, it is what it would cost you to buy out all stockholders as well as all lenders to the company, so that you would own all assets without encumbrance.

At the end of the third quarter Encana's market cap was $14.14bn ($19.21 stock price times 736m shares). Total debt was $8.65bn and cash was $0.31bn. Thus enterprise value was $22.48bn.

The latest value we have for reserves (end 2010) is 14.3 trillion cubic feet equivalent (tcfe; here liquid reserves are converted to cubic feet of gas equivalent based on heat value).

Dividing the enterprise value by proved reserves gives $1.57 per mcfe (or perhaps a little less, since reserves probably grew between December 2010 and September 2011).

I have pointed out before that the capital costs in converting promising land into proved reserves are approximately $1.50 per mcfe (Encana: hold and buy more later).

What this means is that Mr Market is making you an offer. If you are willing to pay back Encana for sunk capital costs used in mapping out current proved reserves, you can have those reserves and all the rest of the gas under all of Encana's lands. In other words, the current market price on Encana assumes that producing current proved reserves will do no better than pay back sunk capital, and puts a value of ZERO on all further gas resources not yet proven. These gas resources are several times proved reserves; they are likely to be produced at significant profit in the coming years, and you can now buy those profits for a price of … absolutely nothing.

Overall this is an excellent example of the market's short-term thinking and – what else can I say – utter silliness. A few years ago these gas resources were worth a lot, because gas was, at that time, being produced at a profit. Now, because gas is being produced without a profit, the market is valuing decades of future profits at zero as well.

One caveat: While I have absolutely no doubt that the gas in the ground that Encana owns is worth a great deal more than the current market valuation implies, one also needs to consider the management of the company. Companies do not always make good use of valuable resources and, in extreme cases, resources are thrown away. Encana, in particular, pushed hard to increase production just as the gas price was falling to record lows. I suppose they thought the price would not fall so far. But one must ask whether they will, in fact, turn their resources into profits. That will be the subject of another post.