Encana: Will The Rally Continue?

| About: Encana Corporation (ECA)

Summary

Encana's shares have shot up remarkably in 2016, especially after its robust quarterly report in February that illustrated the strength of its operations.

Encana seems well-placed to do well in a weak pricing environment as it is improving production at its high-margin, core assets that can deliver robust production at low costs.

Encana’s core assets at the Permian, the Eagle Ford, the Duvernay, and the Montney generate approximately 30% returns at oil prices ranging from $30 to $50 per barrel of oil.

Encana will improve its return profile from the core assets further this year by way of capital savings and lower D&C costs, which will further improve its return profile.

The scenario in the oil market is improving and this clearly reflects in the stock price performance of Encana (NYSE:ECA) so far this year. Encana's shares have made an impressive comeback on the stock market in 2016, rising close to 40%. What's even more interesting to note here is that Encana has shot up more than 120% since releasing its latest set of results on February 24, indicating that the rise in its stock price is not only about the oil price recovery, but also about Encana's operational improvements that allowed it to deliver an impressive bottom line beat.

In fact, Encana is among those shale oil producers that are worth buying in a $35 oil price environment, according to Goldman Sachs. This is because the company has taken enough steps to improve its production profile and reduce costs even in a weak pricing environment. Let's take a closer look at the steps undertaken by Encana to improve its operational profile as this will allow the company to strengthen its financial performance in the long run.

Focus on high margin assets

As a result of the downturn in oil and gas prices, Encana has elected to divest non-profitable assets and at the same time, it is concentrating on improving its production at higher margin assets such as the Permian, the Eagle Ford, the Duvernay, and the Montney. In fact, the company spent approximately 90% of its capital expenditure in 2015 on these assets to lower costs and increase production rates. Most of this investment was directed toward reducing drilling and completion times, drilling longer laterals in a bid to enhance production, increasing the number of wells on each pad to increase efficiency, and retaining high-quality acreage through a vertical drilling program

As a result of these investments, Encana was able to significantly increase production for these core assets and reduce costs simultaneously. For instance, the combined production from these core assets came in at around 274,000 barrels of oil equivalent per day in the fourth quarter of 2015, representing an increase of 10% sequentially and about 36% year over year.

The most interesting point to note here is that Encana increased higher margin production from these assets, accounting for 70% of its total production in the fourth quarter of 2015 as compared to a 50% contribution from higher margin production in the year-ago period. More importantly, the company managed to increase its production at the core assets despite reducing capital costs by 25%.

As a result of higher production and lower costs, Encana was able to post an improvement in the operating cash flow last quarter despite low oil prices. In fact, the company generated nearly $383 million in cash flow from operations that not only exceeded its capital expenditure, but also increased nearly 3% sequentially. The reason behind this positive operating cash flow performance was because Encana's core assets generate approximately 30% returns at oil prices ranging from $30 to $50 per barrel of oil.

Thus, it is clear that Encana has been able to prove its business model as it has been able to post positive cash flow by reducing costs, enhancing production, and bolstering the rate of return on its assets. Looking ahead, the company is looking to do the same as it has lined up more cost cuts and efficiency measures in 2016.

Why Encana will get better

Encana aims at delivering production of approximately 340,000 to 360,000 barrels of oil equivalent per day in 2016. Although this production guidance signifies a drop of 11% as compared to last year, Encana plans to attain this level of production with a capital budget that is 55% lower than 2015. In fact, its latest capital expenditure guidance of $900 million to $1 billion represents a reduction of 40% from its original 2016 guidance.

The good part is that due to such low levels of capital expenses and robust production levels, Encana will be able to achieve capital savings of $50 million this year. More importantly, the decline in production will come from Encana's non-core assets, while the core assets are anticipated to deliver production growth.

This is good news for investors for two reasons. First, the core assets carry higher margins as discussed above, and second, Encana plans to reduce operating and field costs for these core assets that will further expand margins this year.

For instance, Encana expects production from Duvernay to grow significantly in 2016 as it plans to bring the new 10-29 plant online and operate two rigs throughout the year. At the same time, it plans to pursue further cost reductions. For instance, Encana will maintain its production level at the Eagle Ford, but expects its drilling and completion costs to drop by 20% to $4.3 million per well this year from 2014 levels.

Meanwhile, Encana is shifting its focus to more condensate-rich parts of the play at the Montney asset, projecting a production growth rate of over 50% on an annual basis through 2018. Moreover, Encana has identified 1,000 opportunities across the company that will allow it to lower its lease operating expenses. These initiatives include the usage of recycling water and reducing disposal and trucking costs, which will help the company reduce water management costs by 15%.

All in all, Encana will reduce its cost structure by over $550 million in 2016 as compared to last year. This includes capital efficiency savings of $200 million to $250 million of new cost reductions versus the original guidance for 2016. The following chart clearly reflects the impressive decline in Encana's cost structure this year:

Source: Encana

Conclusion

Encana's focus on production growth from its high-margin core assets that carry lower costs and have a robust production profile will allow it to improve its return profile even in a weak pricing environment. As such, despite Encana's tremendous run this year, it makes sense to remain invested in the stock as it is capable of going higher.

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.