Encana: Exchanging value for income

29 Sep 2014 by Jim Fickett.

Encana, in overcorrecting for previous mistakes, is destroying long-term value in order to increase short-term income. The good news is that investors do not understand what is happening so, if an exit is necessary, optimism driven by improvements in short-term income will probably provide a good exit point.

The strategic management of Encana has been unfortunate. On the one hand, they deserve credit for seeing the coming revolution in shale gas before others, and acquiring a substantial portfolio of land at excellent prices. On the other hand, since then, they have made two major moves that turned out to be mistakes, and are in the middle of a third move that is destroying value.

1) In 2009 they spun out all liquids-producing assets into Cenovus, becoming a pure-play natural gas company. (Here “liquids” includes oil and the lighter “natural gas liquids” - NGL - such as butane.) Only two years later the annual report strongly emphasizes trying to acquire and develop liquids-rich locations and ramp up liquids production (“we are adapting to the market reality by shifting our investment and operational excellence towards growing our oil and NGLs production … invested - about $515 million – in acquiring prospective oil and liquids-rich lands.”)

2) In 2010, as the natural gas price began a 3-year trend to new lows, they set a goal to “double [natural gas] production per share in five years (from 2009 base).” Two years later gas production was lower than in 2010. And currently they have an explicit goal of increasing liquids production and reducing gas production.

3) The great strength of Encana is a very rich stock of natural gas reserves and economic contingent resources but, in the current push to increase liquids production, Encana is selling natural gas land at fire-sale prices. For example, according to a news release dated 31 Mar 2014, “Encana Oil & Gas (USA) Inc., has reached an agreement with an affiliate of TPG Capital (TPG) to sell certain natural gas properties in the Jonah field located in Sublette County, Wyoming, for a purchase price of approximately US$1.8 billion. … Estimated year-end 2013 proved reserves for Jonah totaled approximately 1,493 billion cubic feet equivalent (Bcfe).” The Jonah reserves were thus priced at $1.20/Mcfe, probably less than they cost the company to acquire (Encana checkup).

At the same time that Encana is selling its gas resources when prices are at record lows, they are buying liquids-rich land after all the other gas producers made their similar moves, and hence are paying peak prices. For example, the FT wrote today, “Encana of Canada has become the latest company working in North America’s shale reserves to make a leap to reduce its reliance on gas, and increase its oil production, by agreeing a $7.1bn deal to buy US-listed Athlon Energy. The deal unveiled yesterday is worth $58.50 per share in cash – almost three times the price of $20 that Athlon floated at last year.”

I invested in Encana because I thought the gas in the ground was undervalued by the market, and I wanted to be a part-owner for the long term. Currently the company is disposing of a significant fraction of that gas for far less than its long-term value. So it is unclear whether my value proposition is intact. There is, unfortunately, insufficient information in current news reports to fully evaluate the effect of current actions on reserves and resources.

Fortunately, current commentary in the news is very positive about Encana's dispositions because (and with this I agree) the current strategy is likely to increase near-term income. Thus my strategy is (1) to wait for the 2014 annual report, in order to evaluate the overall effect of dispositions and acquisitions in 2014 on reserves and contingent resources and (2) if my long-term value investment thesis is no longer convincing, wait for a quarter with good news on income, and hopefully a pop in the share price, to sell.