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A worst-case scenario for Encana (is very unlikely) [ClearOnMoney]
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A worst-case scenario for Encana (is very unlikely)

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Commentary

A worst-case scenario for Encana (is very unlikely)

25 Jan 2012 by Jim Fickett.

In this post I look at the worst scenario I can think of for Encana, examine it in some detail, and conclude that it is very unlikely to occur. Incidentally, the Encana stock price is up 17% in the last few days.

When I'm waxing poetic about a possible investment, my partner likes to ask me, “OK, so what's the nightmare scenario?” It's a good question. In this post I'll try to give a realistic appraisal of the worst scenario I can think of for Encana. In short, the nightmare scenario goes something like this:

  • Many gas companies shift to drilling “wetter” wells, with a higher proportion of natural gas liquids (NGLs), and make enough money from the liquids that they can afford to make no money on the gas.
  • These wetter wells still produce a lot of gas and, as a result, the gas price stays low for several more years
  • Encana, having just split off its oil assets into a new company, has a harder time than some companies in rescuing themselves by producing more liquids, and simply cannot make money

A number of people are taking the first two points quite seriously. I haven't seen any serious quantitative analysis, but there is at least one case in which well-informed people, with access to excellent data, take this view. This is the Energy Information Administration, in their preview of the Annual Energy Outlook, which I mentioned in a previous post.

They project that US shale gas production will keep growing very strongly:

And, at the same time, prices will stay quite low for at least 10 years:

With increased production, average annual wellhead prices for natural gas remain below $5 per thousand cubic feet (2010 dollars) through 2023 in the AEO2012 Reference case. The projected prices reflect continued industry success in tapping the Nation’s extensive shale gas resource. The resilience of drilling levels, despite low natural gas prices, is in part a result of high crude oil prices, which significantly improve the economics of natural gas plays that have high concentrations of crude oil, condensates, or natural gas liquids.

The EIA also project that, despite the low price, the share of natural gas in the overall US energy picture will remain constant, at 25%, over the next 25 years.

The overall EIA projection is implausible in two important ways.

First, it is hard to believe that no matter how much effort is shifted to looking for and producing oil and NGLs, the volume of gas produced will continue to grow all the same. They provide no supporting analysis, so it is impossible to tell whether this is based on hard data, models, or currently fashionable opinion. One prominent example suggests that this idea is wrong.

While Encana only decided in the last few months to concentrate more on liquids, Chesapeake Energy already made a clear strategic commitment to finding and producing more liquids in early 2010. This change in strategy took a while to implement, but it is in full swing now. For the first three quarters of 2011 the year-over-year increase in quarterly liquids production was, Q1: 54%, Q2: 64%, and Q3: 93%. And with all the increased spending on liquids production, what happened to gas? The year-over-year changes in natural gas production were Q1: 16%, Q2: 3%, Q3: 1%. So if Chesapeake is in any way typical, we can expect the growth in gas production to slow drastically as emphasis switches to liquids. (In addition, Chesapeake just announced that it will actually cut gas production 8%.)

The second aspect of the EIA projection that I find quite implausible is that, even though gas prices are predicted to remain very low, the share of gas in the overall energy picture is projected to remain unchanged. Here is a graph from a recent Encana presentation, showing an historical comparison between the cost of a unit of heat from oil and the cost of the same unit from coal or natural gas. The dashed lines are predicted costs based on the futures market, which is giving a reading very similar to the EIA projections.

Is it really likely that the cost of heating and electrical power from gas will remain much cheaper than it has been relative to other fuels, and at the same time homeowners, manufacturers and power generators will not migrate to gas? Come now.

Keep in mind that projections like these are always heavily based on continuation of current trends and belief in current estimates. Don't forget that only a few years ago the consensus was that natural gas shortages would persist for decades.

But back to Encana. Based on the above, I don't believe gas production is going to keep increasing while the gas remains unprofitable, even if liquids help. And I don't believe the price will stay so low, since that low price continues to drive demand growth. But how bad would it be for Encana if indeed the price did only slowly rise from the current $3 or so to the EIA and futures market estimate of $5 or so?

The first thing to note is that a $5 price would be fine for Encana – they claim they can make a decent internal rate of return at a price of about $4. Second, although it is true that they divested the assets that were primarily oil, the gas assets that remain include a fair proportion of liquids. According to the 2010 annual report, their proved reserves, as of Dec 2010, were split evenly between natural gas and associated liquids. So they will likely have no trouble in following the now popular strategy of producing more liquids to survive until the gas price rises.

All in all, the case is very strong for a rising gas price and, even if the price stays low for several more years, Encana will manage all right until more realistic prices return.