I am currently searching for a high risk/high reward company based on the fact that natural gas prices -- and especially oil prices -- might see a recovery by the end of 2016. The first target on this hunt is Encana (NYSE:ECA). Should you invest in Encana?
Funds Flow From Operations
The annual financing cost on the company's $6.5B debt is about $420M. To compare this figure, let's take a look at the estimated operating cash flow for 2016.
Of course, this figure is highly dependent on the oil and natural gas prices. Let's take a look at the following table I created based on the 2016 guidance released by the company, which compares funds from operations (FFO) to the WTI oil price ($/bbl) and the Henry Hub natural gas price ($/MBTU).
Source: Encana and my own work.
As you can see, the most bearish figure is a potential catastrophe for the company in terms of capex for 2016. Indeed, the company plans to spend $1.5B to $1.7B of capital in 2016.
I used the highest guidance figures as they are conservative in my view. Indeed, the company had operating cash flow of $450M in Q3 2015, when WTI oil price was $46 per barrel and Henry Hub natural gas was $2.75 per MBTU for the quarter. This adds up to $1.8B for a year compared to our $1.2B with WTI oil price of $50 per barrel and NYMEX natural gas price of $2.75 per MBTU.
Therefore, FFO should be higher in my opinion, especially because it removes working capital variations. It seems to me that the company is using very soft numbers for their guidance, maybe to prove itself wrong with better numbers late this year.
A base case in the current environment would be to consider an average oil price of $40/bbl and an average natural gas price of $2.25/MBTU for the current year. Therefore, financing costs of $420M would represent 36% of the total 2016 FFO.
Furthermore, the company would need to cut its 2016 capital program as management remains committed to keeping its investment grade status. It would be prudent to use their existing credit facility with moderation only.
Debt Matures in the Long Term
On the other hand, Encana has a clear advantage compared to other leveraged E&P companies -- its debt matures in the long term.
Source: Q3 2015 presentation.
As you can see, the schedule is very much an advantage for the company. The first maturities are due in 2019 and 2021 and then in the long term, starting in 2030.
Of course, I believe the company will survive the current downturn, mainly because its debt matures in the long term. The company will be under great financial stress, especially this year as we can see from its estimated 2016 funds flow from operations. The interest payments will use a great part the cash generated by the company.
If we believe the guidance in terms of cash given by the company, the 2016 capital program should be lowered. I believe we will learn a bit more from the Q4 2015 earnings release in two weeks.
However, we may start to see the light at the end of the tunnel in terms of oil and natural gas price by the end of 2016. Therefore, Encana will be one of those high reward/high risk plays because of the leverage the company carries.
I will not buy the company immediately. Be patient and you will be rewarded by buying the stock at a cheaper price in the short to medium term.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.