Increased stake in Encana

15 Feb 2011 by Jim Fickett.

I had a stake in Encana of 1.5% of my portfolio, purchased some years ago. On Monday I doubled that to 3%. Recent results confirm that reserves are undervalued. In addition, cash inflows from joint ventures and new efficiency initiatives both suggest Encana can increase income even in the current low gas price environment.

In a previous post I made the investment case for Encana. In short, I think they control large gas resources and reserves that are, on a long-term view, significantly undervalued. When writing the previous post I felt it was worth waiting to buy, in case the short-term picture, in today's environment of low gas prices, grew darker. In today's post I will not repeat the whole investment case, but rather will just describe what has changed with the latest data.

Reserve replacement

In 2009 the old Encana split into two companies, Cenovus, an oil and refining company, and the new Encana, a pure play gas company. Because some of the old Encana's gas deposits were associated with the oil that went to Cenovus, both gas reserves and gas production dropped steeply in 2009. However both reserves and production began to grow again in 2010:

(Here and further below, all new data are from the Q4 investor material on Encana's website, unless otherwise attributed. Some data are preliminary and unaudited. At this point only combined liquids and gas reserves have been given by Encana for 2010; I've assumed the proportion of liquids to gas is the same as in 2009.)

Encana also gives, in addition to reserves, numbers for “economic contingent resources”. This category was not clearly defined before, and I mostly ignored it in my previous analysis. This year Encana provides a more detailed definition:

Economic contingent resources fall into three categories: low estimate (1C), best estimate (2C) and high estimate (3C). The three classifications of contingent resources have the same degree of technical certainty as the corresponding reserves categories. In determining their economic viability, the same commodity price assumptions are applied as estimating proved, probable and possible reserves. Contingent resources are not yet commercial due to contingencies such as the timing and pace of development, or the need for additional infrastructure. The low estimate is the most conservative category and carries with it the greatest degree of confidence – 90 percent – that these resources will be recovered.

Given that the most conservative category of economic contingent resources stands at 20.1 trillion cubic feet equivalent (Tcfe), which is about 17 times 2010 production, it is likely that Encana will have no trouble increasing reserves for many years.

Reserve valuation

None of the reserve valuation calculations that I put forward in the previous post has changed greatly with the latest data. So, in my opinion, Encana is significantly undervalued for the long term.

Short-term profits

The gas price continues to be depressed and, for the short term, it is important to understand how Encana is dealing with this. Revenue from the sale of gas continued to decline in 2010, and may do so as well for much of this year.

This is mainly because Encana hedged, when prices were higher, the sales price of much of then-future production, but the fraction of production that was hedged in advance has been going down (and stands at about 50% for 2011).

On 11 January Encana made a very interesting presentation at an investor conference in New York, in which they make the claim that they are much more efficient at producing shale gas than most of their competitors, and can operate at a profit with gas prices as low as $3.85. That is a remarkable number, and the news caused a noticeable increase in the share price.

Joint ventures

Encana has set a goal of doubling production per share in the next few years. It is, of course, somewhat challenging to find the capital to do that when gas prices are so low. The solution is joint ventures. In the conference presentation mentioned above, a large number of joint ventures is mentioned, and an example structure is described in which the partner puts up 75% of the capital and receives half of the production revenue. Thus the willingness of joint venture partners to lose money in order to get in on the shale gas game is enabling Encana to stay on track for their goal of doubling production.

Most recently, an intended (not yet approved) joint venture was announced with PetroChina, in which PetroChina will pay C$5.4 billion for a 50% share in the business assets (including reserves and current production) of one area. The relevant proved reserves are about 1 trillion cubic feet equivalent. This would imply a price of $5.40 per thousand cubic feet – far more than the usual price in a mineral rights transaction. So clearly PetroChina is undertaking this joint venture primarily to gain access to Encana's technology and know-how. In any case, this is one more transaction that will give Encana the capital to continue increasing production.

As a side note, for the natural gas business generally, a large number of loss-making joint ventures were announced in 2010, suggesting that gas could stay cheap longer than I had previously thought. But loss-making deals are self-limiting, of course, and the price will eventually correct.

Conclusion

My reason for buying Encana is a long-term one – I think resources and reserves are significantly undervalued for where the gas price will be in the future, and this will eventually be reflected in net income.

In the short term, I would not be surprised to see a few more quarters of lackluster results. On the other hand, the stock market is anticipatory, and whereas a few months ago only a few far-sighted analysts were noting that the gas price would have to rebound, now I run across many mainstream commentators and fund managers who are saying that gas stocks are undervalued for the long term. So it does not seem too early to buy.

It is also worth noting that Encana pays a decent dividend (currently 2.5%). This increases the margin of safety, and provides some return while waiting for capital appreciation.