Major Changes At Encana Make It A Legitimate Oil Growth Play Now

May.22.14 | About: Encana Corporation (ECA)


Encana revenues and earnings benefited from higher natural gas prices in Q1 2014.

Encana management has made several positive fiscal moves.

Encana announced the acquisition of 45,500 net acres of Eagle Ford Shale. These will be immediately accretive to earnings.

Recent EOG results with both higher levels of fracking proppant and slick water fracking will likely increase IPs and EURs by huge amounts.

Encana should be able to copy EOG’s technology for its Eagle Ford acreage. This should increase current estimates significantly, including reserves.

Encana Corp. (NYSE:ECA) made its reputation as a natural gas E & P company. When natural gas prices fell through the floor in recent years, ECA started to try to increase its almost non-existent oil development. Oil prices have been much more stable than natural gas prices. Diversifying into oil was a solid strategy. With the recent events, ECA has finally become a significant oil company.

On May 7, 2014, ECA reached an agreement for its wholly owned subsidiary, Encana Oil & Gas (USA) Inc., to acquire approximately 45,500 net acres in the heart of the Eagle Ford in Karnes, Wilson, and Atascosa counties in south Texas for $3.1B from Freeport-McMoRan (NYSE:FCX). In Q1 2014, this acreage produced 53,000 Boe/d; and it has an estimated drilling inventory of more than 400 locations. Q1 2014 production was approximately 40,000 bopd, 6,000 bpd of NGLs; and 44 MMcf/d of natural gas. Operating cash flow was US$327 million for Q1 2014. The properties had estimated net proved reserves of 59 million Boe and estimated net proved and probable reserves of 69 million Boe at year end 2013. This transaction is expected to be accretive to cash flow. It is expected to roughly double ECA's current oil production. For Q1 2014 ECA's oil production was 32,100 Bopd. Its NGLs production was 35,800 bpd; and its natural gas production was 2.809 Bcf/d. The Eagle Ford acquisition makes ECA a significant oil producer.

ECA sold some of what it considered "non-core" assets to maintain a good debt balance. On April 29, 2014, ECA's wholly owned subsidiary, Encana Oil & Gas Inc., reached an agreement with an undisclosed purchaser to sell properties located in Leon and Robertson counties in East Texas for approximately $530 million. This deal is expected to close in Q2 2014 with an effective date of April 1, 2014. For Q1 2014 the production from this field was 113 MMcf/d of natural gas (about 18,333 Boe/d), and 1,200 bpd of oil and NGLs. Hence it did not have a large impact on oil and NGLs production in comparison to the Eagle Ford acquisition described above. The 2013 end proved reserves for this field were estimated to be just over 200 Bcfe of which 97% was natural gas.

On May 12, 2014 ECA closed a different sale of natural gas properties in the Jonah field located in Sublette County, Wyoming to TPG Capital for US$1.8B. In Q1 2014 total production for the Jonah field amounted to 282 MMcf/d of natural gas (about 47,000 Boe/d) and 4,700 bpd of oil and natural gas. The estimated 2013 end proved reserves were 1,493 Bcfe. ECA's Jonah field comprises about 24,000 net acres and 1,500 active wells. The transaction also includes over 100,000 undeveloped acres adjacent to the Jonah field, which are known as the Normally Pressured Lance (NPL) area.

In total ECA has effectively swapped a lot of natural gas production in order to acquire more oil production. Plus ECA paid an additional $0.77B out of pocket. This is leaving out all other costs. As a ballpark figure the production sold amounted to about 18,733 Boe/d more than the production bought for more money. Does this make sense?

Most would think it probably did under the current commodity pricing conditions. The closing price of US Nymex natural gas was $4.473/mmbtu on May 21, 2014. The closing price of Nymex WTI oil was $104.07/barrel on May 21, 2014. If you say the conversion factor of natural gas mmbtu to Boe is 6 to 1 (roughly the energy equivalent), then the largely natural gas assets that were "traded" for oil assets are worth far more than the oil assets gained; and that is without considering the extra $0.77B more ECA paid out. However, with the current pricing 6 mmbtu (or 6 Mcf) of natural gas (1 Boe of natural gas) costs only $26.838. In other words a real barrel of oil costs approximately 3.88 times a Boe of natural gas. If you multiple the real barrels of oil of production acquired in these deals by almost 4 (or divided the Boe of natural gas sold by almost four), ECA comes out far ahead on the transaction. The extra 100,000 net acres of undeveloped land in the Jonah field are hard to calculate a value for; but they are probably what enticed TPG Capital to take the deal. In terms of revenue from current production alone at the May 21, 2014 Nymex prices above, ECA benefited by about +$3 million per day. This is not an insignificant sum.

Overall, this deal appears to give ECA what it wanted -- more oil production and reserves. It makes the company's earnings more stable; and it makes ECA a much bigger oil company. It also gives ECA a good sized bump in cash flow. Of course, as natural gas prices eventually rise back to their historical norm of 6 to 12 mmbtu of natural gas per barrel of oil instead of the current 23.27 mmbtu of natural gas per barrel of oil, the deal will not look as good, especially when you consider the extra 100,000 net undeveloped acres next to the Jonah field that were included in the deal for that field.

On April 30, 2014 ECA further filed an amended restated preliminary prospectus for an initial public offering of PrairieSky Royalty. This spin-off will control 5.2 million acres of land in Alberta. Production is free from government royalties there. ECA is planning to sell 32,500,000 common shares at $23.00-$26.50 per common share for gross proceeds to the company of about US$745.5 million to US$861.3 million. Some think this spin-off could raise as much as C$1.46B. ECA anticipates that it will still own 75% of the shares after the offering completes.

ECA management completed a number of other positive activities. The entire list of activities is extensive. I won't include them all; but ECA completed a tender offer for the company's $1.0B 5.80% notes with a maturity of May 1, 2014; and it redeemed the portion not previously tendered to the company.

ECA says the new Eagle Ford field will become its sixth core growth play. Judging by the recent results EOG has been getting in Karnes County, this field may prove to be an even greater asset than anticipated. EOG Resources (NYSE:EOG) has recently gotten results that are perhaps double previous results by using slick water fracking. EOG has also multiplied previous results by using much more proppant. ECA should be able to copy EOG fairly easily. I think investors can expect to see a lot of growth in this field. Investors could also see ECA re-frack some or many wells to increase their flow rates and their EURs (expected ultimate recoveries), although the company has not made any statements along this line yet (that I know of). If investors want to hear more about these recent fracking advances follow the link here.

The other five "core" fields are the DJ Basin, the Montney, the San Juan, the Duvernay, and the Tuscaloosa Marine Shale. ECA reported positives for each of these fields in Q1 2014. In addition, ECA reported $2.2B of cash and cash equivalents as of March 31, 2014. It reported $4.2B of unused bank credit facilities committed until June 2018. It reported the previously mentioned $1B of debt principal settled with cash (and no further debt maturities until 2017). All told ECA seems to be firing on all cylinders; and the new cash flow from the new Eagle Ford field should improve its fiscal situation. It may even lead to an increase in the 1.20% annual dividend soon.

On top of the good strategic moves ECA has been benefiting from the higher natural gas prices in Q1 2014. Many think these higher prices are likely to continue. A number of experts expect them to increase as the many new forms of demand such as LNG export starting up in late 2015 and an increase in the natural gas pipeline exports to Mexico over the next few years. Investors who are interested in reading more about this should click here for a relevant article.

The results for Q1 2014 reflected the higher demand and higher prices seen for natural gas in Q1 2014. ECA generated cash flow of approximately $1.1B (or $1.48 per share). This was an 87% increase on a per share basis from Q1 2013. Net earnings were $116 million (or +$0.16 per share) compared to a loss of -$431 million in the year ago quarter. Operating earnings were $515 million. This was a +192% year over year improvement. Liquids volumes were up +56% year over year to 67,900 bpd. This last figure does not include the new Eagle Ford production capacity. Natural gas production was down 2% year over year to 2.8 Bcf/d. The company also realized approximately $40 million in cost savings in Q1 2014 due to organizational realignment and operating efficiencies. There were many drilling efficiencies realized.

All told, ECA seems to be doing a lot right. It should realize revenue and EPS growth from the recent moves. Further, the Eagle Ford property's growth potential and reserves potential may be far underestimated if investors think ECA may be able to copy EOG's latest improvements in drilling and completion technology. ECA is a buy.

The two-year chart of ECA below provides some technical direction for this trade.

Click to enlarge

The slow stochastic sub chart shows that ECA is near oversold levels. The main chart shows that ECA is in a strong uptrend. However, that uptrend may be overbought for the near term. A small sideways pattern has developed in the last couple of months. ECA could either go up further or fall from here. With both the 50-day and the 100-day SMAs far above the 200-day SMA, a likely near-term outcome is a fall. The stock price could alternatively keep going sideways. However, a move downward is very likely, especially if the overall market falls as some are predicting.

Still the Eagle Ford buy should continue to be an upward stimulus for some time. If natural gas prices stay high (or go higher), that would be a catalyst for a higher ECA stock price too. Some think natural gas prices will rise to the $5-$7/mmbtu range in the next couple of years. Since they were already near the high end of that range in Q1 2014 due to the abnormally cold winter weather, the $5-$7/mmbtu range looks ever more believable as a 1-2 year target.

ECA has a mean analysts' recommendation of 2.6 (a hold). I rate it a buy. The high natural gas prices are helpful to ECA's profit margins. When you combine these with the new Eagle Ford play potential (and the instant revenue gains), ECA is easily a buy. The analysts most likely just have not gotten around to raising their ratings on it. However, week over week the average analysts' rating (of 21 analysts) did improve -0.2 from 2.8 to 2.6 (a higher hold). I have every faith that even the brokerage analysts will soon rate ECA a buy. Meanwhile investors probably will have a better opportunity to get into the stock.

The only caveat is that the overall market could turn downward at almost any time. With a Beta of 1.37, ECA would theoretically follow the market closely. For this reason investors probably want to average into the stock over the next six months to a year. That way they will not get stuck with a price at or near a near-term high. I believe the stock will eventually go much higher; but who wants to be holding a lot of it if the overall market takes a nasty turn downward?

NOTE: Some of the fundamental fiscal data above is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ECA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.