Tomorrow is the earnings call for Q2 2014 at Encana (NYSE:ECA) and I expect some good news.
A bit of history first: ECA emerged as a pure play on natural gas (NG henceforth) in December 2009. It had split its oil business (Cenovus (NYSE:CVE)) in a separate division so as to focus on all its growth opportunities in its different shale plays. With hindsight, the timing of this split could not have been worse. Natural gas prices cratered due to the shale revolution and the lack of export opportunities (LNG stations) and excess supply. The stock quickly slumped and has remained at very low levels ever since.
Fast forward to June 2013 and the arrival of the new CEO, Doug Suttles. At that time, the company had already understood that its financial future was dependent on switching to "liquids" (NGLs and oil) and had already started shifting the ship in that direction. The year before (2012), it secured significant JVs with Asian partners who helped alleviate any financial constraints by sharing a significant amount of the Montney and Duvernay development costs.
Since the CEO's new arrival a year ago, the firm has transformed itself at a rapid clip. And the market has not caught up with the change. Well, it did for a while, with a strong performance at the beginning of the year (with the stock going from $18 to $24.5 helped by strong NG prices). But since then it retraced half of those gains in the last month, and the stock is down back to $21.5 (NG spot prices have dropped by 25% in the same period).
A significant part of my thesis in what follows is that ECA is not a natural gas pure play anymore. Instead, it now has a much more balanced portfolio of assets that allows it to switch back and forth between NG and oil assets (in terms of drilling); a valuable diversification benefit, or natural hedge, given how unpredictable commodity prices are.
Let's talk valuation. First of all, the easy part: Let's use some hard numbers from transaction and market data to determine the enterprise value. All data is from the firm's investor presentations, 10-Qs, press releases and peer firm's investor presentations.
What is the enterprise value of ECA? It corresponds to the amount necessary to acquire all of the firm's future free cash flows. By definition, it is equal to MV of equity + MV of debt (approximated by book value of debt) - Cash on hand (which can be used to pay down debt). Here are the numbers:
As of today, the market capitalization is equal to $16Bn.
- Cash $2.160 Billion on 03/31/14.
- Debt $6.330 Billion on 03/31/14
- Net debt $4.170 Billion on 03/31/14
Now, since end of Q1 2014, we have had several big transactions:
1. Partial spin-off of PrairieSky (OTC:PREKF) -- funds raised (gross) 1674.4 (less after IB fees)
2. Asset sales -- a. Big Horn $1800; b. Jonah $1800; c. East Texas $530
3. Asset purchased -- EagleFord $3100
So the net debt is currently $6330 - (2160+1800+1800+530+1674-3100) ~ $1500M
This number of course assumes that they received all the proceeds from their asset sales (which is not the case quite yet) and that the operations were free cash flow neutral for Q2 (not a bad 1st order approximation). If that is correct, then the enterprise value (MV + Debt - Cash) is about 17.5Bn, which is significantly less than the numbers found on websites such as Yahoo Finance that are using end of Q1 values.
For that amount of money (assuming no takeover premium), what do you get? You get six world class resource plays (shale) that the firm is touting in its investor presentations lately. They include the five core plays identified in the restructuring efforts announced late last year plus the recently acquired EagleFord assets. I list them in turn with their net acreage:
- Eagleford: 45,500
- DJ Basin: 49,000
- San Juan: 176,000
- Tuscaloosa: 200,000
- Montney: 575,000
- Duvernay: 253,000
Here's a look at the Canadian assets first:
The Montney production is increasing at a rapid clip. It is in full "industrial" or "hub" production mode with pad drilling. Costs are coming down every quarter. In Q1 2014, the firm claimed that all of their latest wells produced significantly above their type curve. They have a dominant position in the Montney, they actually have significantly more gross acreage (more than 800,000 acres!) but the net position reflects the fact that they signed a significant JV with an Asian partner that is carrying a significant portion of the drilling cost in exchange of some of its production. Encana is the operator. The scale of the resource play is twice as large as the Eagleford by certain estimates. Encana reports 12% liquids on average out of those wells, making them very profitable in the current commodity price environment.
Duvernay is a relatively new play still being delineated in its southern portion. It produces a significant amount of condensates, which trades at similar levels to WTI. The northern part (Kaybob) of the play is producing very profitable wells and ECA is already in industrial production mode there. Yoho Resources (OTCPK:YOHOF), a small player with acreage just next to ECA recently announced two very strong wells as well. Again, ECA has secured the sweet spot of the play and simply put, they again own a good portion of the play (approximately half according to the firm's investor presentation). It also formed a JV there to help accelerate the development of the resource. In the southern portion (Willesden Green), we are still waiting to hear how well the play is going to perform. The news is so far encouraging and ECA should announce before year-end the state of the play.
Now a look at its U.S. operations:
The DJ Basin asset is a relatively large area with a core position in the heart of the Wattenberg field (Niobrara shale is one of the resource they are drilling there). ECA does not disclose much per play but if you want to read about the quality of their acreage, they are right next to Bonanza Creek (NYSE:BCEI), which has seen its valuation go up more than 200% in the last two years. Multi-stacking and down-spacing are in order here. ECA itself stated that the wells improved dramatically in Q1 (both in terms of cost (through longer laterals) and production).
The San Juan play is very oily. ECA is a first mover in the oily part of the region. It is still being delineated somewhat and has some permitting issues but they have started the industrial or hub mode of drilling there and managed to significantly reduce costs already. WPX Energy (NYSE:WPX) is another big operator in the play. WPX obtained very good results in Q1 2014 and just added 6,000 acres to their position, which is encouraging.
Then there is the Tuscaloosa Marine Shale (NYSE:TMS). This one is somewhat of a wild card at this point in time. The entire play is basically run by three different companies: Goodrich Petroleum (GDP), Halcon (NYSE:HK) and Encana. All three companies have large acreage positions and all are still proving their portion of the play. Wells are expensive there and all the players are still trying to crack the code to obtain consistency with their well results. So far, Encana has reported encouraging results. One of their deliverables for 2014 is to delineate more fully the play. Hopefully, we will hear more about it in the call or in the coming months.
Last but not least: Eagleford. The acquired acreage is in the sweet spot of the play (Karnes Trough area); all around them is EOG, which is producing the best onshore wells in North America. The operational cash flow of the play was greater than $300M in Q1 2014. Freeport McMoran (NYSE:FCX), its previous owner, actually already developed a significant portion of the play. The goal for ECA is to apply their skill to further increase the value of this asset. Given the remaining 400 well locations (before applying any EOR techniques), there is still room to improve the play. The good news is that it is already self-financed, and doubles ECA's oil production overnight. The price tag was high but fair: Few assets of this quality come to the market and ECA was there to take advantage of it and in doing so took a jump towards meeting their long-term (2017) goals.
Not only do you get those six plays, you also get at least three other valuable plays: Haynesville, Panuke, Piceance.
Panuke is in the news a lot given the $19 per Mcf obtained during Q1 2014. It went online in December 2013 and the timing was perfect with the cold winter vortex. It has premium pricing as it directly serves the North Eastern seaboard. Obviously, this asset will not contribute as much in Q2 and going forward but Q1 did show how valuable this asset can be. Panuke is fully operational, and while it will not bring in much outside of winter, it has the potential to contribute nicely to profits in the winter as it did in Q1 with more than $300M in operating profits.
Both Haynesville and Piceance are very nice NG heavy assets too, and they have basically been put to pasture (in terms of capex drilling) until NG prices improve. While ECA understands it is wiser to redirect capex dollars to oilier plays at this point in time, these assets remain very valuable. Haynesville can produce very big gas wells and will show its value once LNG stations are online and NG prices head back toward the $5-$6 range. The idea here is to keep the optionality of increasing NG production when pricing is more favorable.
So EV is approximately $17.5Bn and for that, you get six world class assets, a 54% stake in a unique oil&gas royalty firm (PrairieSky is a cash machine) plus three best-in-class NG assets that can be switched on at any time. Are these assets worth more or less than $17.5Bn?
Well, first, we can look at two market-based data points:
- PrairieSky's stake is valued at $2.8Bn (70.2M shares * $40) using today's market price.
- EagleFord's stake was purchased recently at $3.1Bn. Let's assume it was the fair price for it.
So we now have $5.9Bn already accounted for. This leaves $11.6Bn for the following assets, with a very rough estimate (comments welcome) of their valuation next to each of them:
- Montney ($5Bn)
- Duvernay ($2Bn)
- San Juan ($1Bn)
- DJ Basin ($2Bn)
- TMS ($1Bn)
- Deep Panuke ($1-2Bn)
- Haynesville ($3Bn)
- Piceance ($3Bn)
For Montney, it is hard to put a value on that acreage; $1Bn per 100,000 acres seems fair if you compare with the EV of much smaller players in the play (Painted Pony Petroleum (PPY), Delphi Energy (OTCPK:DPGYF), Crew Energy (NYSE:CR), Advantage Oil and gas (NYSE:AAV)).
For Duvernay, we can use a similar reasoning; in the Kaybob, they have the ultimate sweet spot (see Yoho Resources, their small neighbor, for details on how well they are situated). For San Juan, it is still early days. Growth is going to accelerate with more rigs added to the play (WPX is ramping up production also).
TMS: Halcon is betting big on the play (and Apollo just provided $400M of financing to help them develop the play). Goodrich is closer to a pure play on the TMS. It has nice gas operations in the Haynesville but the market is valuing a big part of the firm for its TMS acreage (75% of their capex is in the TMS). Current EV of $2.1Bn for 300,000. So conservatively, the 200,000 ECA could be worth $1Bn.
For Deep Panuke, I am just repeating the numbers recently touted in a Bloomberg article ($1Bn seems low). Haynesville is hard to value (pure dry gas, not in vogue nowadays). They have significant acreage in the sweet spot of the play with very productive wells. But with low NG prices, ECA has stopped putting capex dollars there since the beginning of the year. Again, when NG prices go up, this is one of their crown jewel assets. Given their recent divestitures of much less prized NG assets, I put the value at $3Bn.
Last, I put also a value of $3Bn for Piceance. They have a very large acreage position there: 800,000 acres with 8,000 drilling locations according to an investor presentation from last year (this asset is not promoted by the firm these days as it pushes towards liquids). Although it is a dry gas heavy asset, it does have liquid potential in the Niobrara: It produced 5.4Mbbls/d in Q1 2014.
Adding up those values, we get $18Bn (again that is on top of the $5.9Bn for PrairieSky's remaining stake and the Eagleford). So the total is $23.9Bn compared to a current EV of approximately $17.5Bn. That leaves a $6.4Bn valuation gap. Using the current number of shares outstanding for ECA of 740M, this $6.4Bn gap would correspond to $8.6 of additional value per share, corresponding to a 40% discount from current market valuation. Admittedly, these are rough estimates. I would be surprised if the firm were to sell many more of those key assets in the short term (except Deep Panuke). They have been saying repeatedly that the idea is to build optionality. The assets they sold were arguably the "weaker" ones in the stable. And now they have a much more balanced portfolio of assets to develop. The point here is to highlight the disconnect between the valuation implied by the current share price and the value of the underlying assets the firm has.
So why the current discount? I see three reasons why and I argue below why the discount is undeserved.
1. Canadian discount
2. NG discount
3. Conglomerate discount
Regarding the first point: It's undeserved. It is a Canadian firm, but half of its assets are in the US. The two key plays in Canada are Montney and Duvernay, two world class plays and they have the sweet spots in both. Deep Panuke gets premium pricing and as such is not subject to the capacity constraints issues in the AB/BC. DJ Basin, San Juan, Eagleford, Haynesville, Piceance and TMS are all in the US.
Regarding the second point: It's also undeserved. Their oil production is growing fast and the Eagleford is a game changer. The transition to liquids is happening much faster than what the markets are factoring in. They are nicely hedged in the short term also (most of their production at $4.17 for the rest of the year) and when the time comes for NG to recover (maybe two to three years from now, who knows?), they can turn on the switch and increase NG production significantly with their remaining NG assets. They made many transactions recently and I guess the conference call will give more clarity on this front. They have acted swiftly, but not hastily.
Regarding the third point: It's also undeserved. While it was a completely unfocused firm less than two years ago with capex spread out of more than 20 plays (!) and probably deserved a discount back then, ECA now has its capex dollars focused on their six core plays (to the tune of 75%). Add the "industrial scale" of their mostly contiguous acreage in each play and you have quite the player, with production across several states and across NG and oil. This type of diversification actually deserves a premium. It mitigates regulatory concerns for firms concentrated in only one play. And, more importantly, it allows the firm to easily switch between NG and oil depending on the pricing environment. I do not know of many firms in the sector that has this kind of flexibility and financial strength to carry out a growth plan without any risk of dilution for shareholders.
I personally view the slide we have been seeing in the last month as a buying opportunity before the ECA ship will have fully righted itself. Your comments below are welcome.
Disclosure: The author is long ECA. I have short, medium and long-term options on ECA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.