Encana checkup

28 Dec 2012 by Jim Fickett.

Encana scraped through 2011, keeping reserves and production approximately constant while also keeping free cash flow (barely) positive. This was accomplished by a (continuing) strategy of selling some assets and partly funding development through joint ventures. It remains the case that the market values Encana's proved reserves at just the value of the sunk capital costs, and values the resources beyond that, which include much that is of comparable quality to proved reserves, as worth nothing. The wait has already been long, but this undervaluation will change.

This post brings some past analysis up to date with more recent data, and addresses some general concerns about the gas industry. All data not otherwise attributed in this post is from the company website.

Strategic adjustment to current conditions has been reasonable

The slump hit Encana at a bad time. They were in the process of ramping up production when it became unprofitable to produce at all. And they let all the oil assets go to Cenovus in a company split, just before all the gas companies began to emphasize liquids production to keep revenues going. But their balance sheet was reasonably strong, and they have adjusted their strategy in a reasonable way.

Their current strategy (based in part on the latest earnings call) is:

  • Keep the machine going so as to be ready for better times. Reserves and production were more or less level from 2010 to 2011. In 2012 they shut in production for part of the summer, but started it up again when demand began to pick up in the fall.
  • Fund capital expenditures from cash flow, not new borrowing. This has been possible by doing some joint ventures and selling some assets.
  • Ramp up liquids. This is difficult for Encana because of the Cenovus split, but they are making progress. In 2012 liquids are estimated to be about 7% of production (by heat value; more by revenue), and they may come close to doubling that in 2013.

Despite some criticism of the sector, Encana's reserve estimates are solid

Arthur Berman, an engineering consultant and general skeptic of the shale gas revolution, suggested in a 2011 presentation that many gas companies had taken advantage of a 2009 rule change by the SEC to increase their reliance on undeveloped reserves. That is, their reserve quality had gone down, starting in 2010, because they were relying less on reserves associated with producing wells, and more on reserves interpolated between wells, based on geology.

Here are Encana's proved reserves over the last decade, broken down into developed and undeveloped.

All of Encana's reserves went down in 2009, because of the spin-off of Cenovus. However the roughly even split between developed and undeveloped has persisted since 2005, and there is no evidence of a decline in reserves quality.

Backing off from this particular issue, note that Encana goes to great lengths to ensure that their annual reserves estimate is carried out in a fully independent manner, by outside experts; their reserves estimates are quite solid.

Profit and free cash flow were positive in 2011

Recall that free cash flow is cash flow from operations less capital expenditures. Since, in this industry, a major capital expenditure is the purchase of new land, I have included all the effects of acquisitions and dispositions in capex.

In 2011 Encana spent more than its available cash flow on exploration and development, replacing production by 180%, but then sold several assets, with the net effect that free cash flow remained positive (just), and reserves about level. This was a reasonable way to take advantage of plentiful, undervalued, resources.

Overall I think it is accurate to say that at 2011 gas prices, with half their sales hedged at higher-than-market prices, they were just breaking even. 2012 production was also about half hedged at well above market prices, so perhaps results will be similar.

No problem servicing debt

Some companies, for example Chesapeake, have run into serious problems with debt during the natural gas slump. This does not appear to be the case with Encana. Long-term debt has not increased in the last few years. Over the last decade Encana has maintained a cash reserve of about 1.9 times annual interest costs, on average. At the end of 2011 that ratio was 1.6, which still leaves a comfortable margin. And operating cash flow for 2011 was about 9 times interest cost. So it seems very unlikely that Encana will have any problem servicing its debt.

To keep the cash flow positive while the gas price is low, they are continuing to divest some assets.

Quality of management

On the plus side, Encana's management

  • foresaw the importance of shale gas, and bought up assets when they were cheap
  • has a reasonable, straightforward strategy now, and has successfully kept cash flow positive and kept the balance sheet out of trouble through a difficult time
  • is generally careful with money; for example, the employee stock plans and retirement plans have modest liabilities
  • has enough respect within the industry to succeed with a number of joint ventures in which they provide less than their share of the capital, in exchange for providing more than their share of the expertise

On the minus side, the timing on the Cenovus split, and the push to ramp production up strongly just before the gas bust, is disappointing. Still, I don't know of any management team that did succeed in preparing beforehand for the gas bubble and bust.

On the whole Encana's management seems reasonably competent, careful with money, and, as far as I can tell, quite honest.

The stock is a bargain

I'll repeat, with current data, what I think is the strongest argument making clear that the stock price is unreasonably low.

Reserve replacement cost is the cost for adding to reserves, expressed in dollars per thousand cubic feet of gas ($/Mcfe). It is calculated as capital spending per Mcfe added to reserves. Taking all capital expenditures (including net acquisitions), and all additions to reserves, for the years 2003-2011 (leaving out 2009 because the split with Cenovus muddies the accounting) gives a long-term average of $1.70/Mcfe. This is close to the industry average for the last three years, estimated from Ernst & Young data, of $1.60/Mcfe. Let's split the difference, at $1.65.

With proved reserves, at the end of 2011, of 14.2 trillion cubic feet (Tcfe), that means Encana's proved reserves represent a sunk capital cost of roughly 14.2 * 1.65 = $23 bn.

At the end of 2011 enterprise value, what you would spend to buy out all stock holders and debt holders, and own the company's assets free and clear, was $21 bn. It is in the same neighborhood now; perhaps a bit higher.

So according to the current market valuation of Encana, a reasonable outlook is this: current reserves will bring in only enough to cover sunk capital costs, with no profit, and all the resources that are not yet proved reserves are worth essentially nothing.

This is particularly astonishing in view of what Encana calls “economic contingent resources”. These resources are supported by roughly the same level of evidence as reserves, and are expected to be produced profitably, just as reserves, but are not yet proved reserves because some part of the infrastructure is missing are the plan is to produce more than 5 years in the future. Those economic contingent resources that are known with 90% certainty are larger in volume than current proved reserves, and are receiving a valuation of essentially zero from the market.

The three classifications of contingent resources have the same degree of technical certainty as the corresponding reserves category. For example, the 1C contingent resources meet most of the same criteria as proved reserves; most importantly, they have the same degree of technical certainty – a 90 percent probability that the quantities recovered will equal or exceed the estimated number. The major factor that prevents them from being included as proved reserves is time. Generally, 1C contingent resources exceed the five-year regulatory guideline for proved reserves development. By adding the qualifier that the contingent resources are “economic”, the resources are high-graded. Shareholders then understand that these resources are expected to be economically recoverable under the fiscal conditions that Encana expects to prevail.

1C contingent resources at end 2011 were 25.0 Tcfe, compared to proved reserves of 14.2 Tcfe.

The market is putting this valuation on the company because, it is true, gas being produced currently is NOT making a profit. In fact, to keep the cash flow positive, Encana (and other companies) have been selling assets. But it would be remarkably illogical to assume that gas companies will continue selling gas at a loss for the long term – they would all go out of business. When the gas price again rises to a level that results in profitable production, the market will suddenly attribute value to Encana's reserves and resources.

One final note on distressed assets

Encana is hardly the only gas company that is being forced to sell assets. It would seem that those with cash to buy such assets are probably getting excellent prices. This suggests that one should look into some of the MLPs that are currently buying gas assets, e.g. EV Energy Partners.