Encana (NYSE:ECA) has enjoyed quite the rally lately, as the stock soared over 150% this year. Natural gas prices has been rebounding with great momentum and there is reason to believe that it will continue to rebound. The terrific management team at Encana also has a strategic plan in place that will allow the business to increase its operating margins by lowering costs and moving its focus from natural gas to oil production. I believe the rally is still in the very early stages and there is still huge room to run from current levels, as management's strategic intiative has just become to come into affect.
Encana has been aggressively acquiring oil assets so that it can become more of an oil producer and less of a producer of natural gas. Encana's oil production segment's revenue stream has grown from 5% to 20% over the last three years and its expected that oil will contribute more to Encana's top-line as we move forward. Encana's greater exposure to oil will allow it to skyrocket once oil rebounds to its historical highs. Oil also has better market conditions compared than gas and usually is cheaper to produce. Last year Encana sold $2.8 billion worth of its natural gas assets in order to finance its transition. Another $625 million asset sale to Alberta is expected and this will help speed up the transition from a gas company to a more diversified oil and gas firm, as the funds will go directly to acquiring more assets in the oil patch. This transition will take many years, but it looks to be going well thus far. A bet on Encana will be a bet on natural gas, and more so a bet on oil in the long run. I believe oil and gas prices will continue to recover as we head into the latter part of 2016. The sale of its gas assets will continue and its oil exposure will increase as time goes on. I believe oil will have recovered to its historic high by the time the management restructuring is complete.
Encana's management team has also been actively cutting costs in order to survive the commodity rout. Encana expects production efficiency to increase by 10-15% this year with corporate expenditures to be cut by 10%. The company showed the affects of its cost cutting initiative in its Q2 2016 earnings last week, as it surprised analysts by posting a Q2 operating profit thanks to the company's initiatives in reducing drilling costs across its various segments. These cost savings will go directly towards its restructuring efforts and allow it to acquire more assets in the Albertan oil patch. Oil is still quite cheap right now, at $45 a barrel. There's no better time to buy assets in Alberta's oil patch then now, with many oil companys looking to sell assets due to their stressed balance sheets in the current rout in oil. Once oil prices do recover, which many pundits believe will happens gradually over the next few years, Encana's stock will slowly shoot back up to historical highs.
Encana is not without its risks, as there are potential issues that may slow down Encana's strategic initiatives. The Alberta Energy Regulator introduced new rules that will make it harder for companys like Encana to do M&A. The strict standards require a certain level of financial strength in order to go through. Encana has a ton of debt, so this may be a problem for them as they go forward. Currently, there is $5.8 billion worth of debt and only $220 million in cash. If Encana can sell more of its gas assets, then we may see the company proceed with its strategic plan. Currently, Encana owns $15.2 billion worth of oil and gas assets, so I believe the firm will be able to eventually proceed with its expansion into the oil patch. However, the primary concern is whether or not Encana gets the most value for the sale of its assets. At the pace Encana is offloading its gas assets, they may not be getting the best value in its deals.
Encana is in a tough transition period, but it will inevitably finish and the company will be in much better shape in times of turmoil going forward. Natural gas production isn't a very high margin business when compared to oil production and I believe the transition towards oil production will result in higher margins and a better return for shareholders of the stock. The business is still transitioning, but free cash flow is expected to skyrocket thanks to the margin improvements brought forth by the transisition.
The stock currently trades at a cheap 1.3 P/B, with a 1.8 P/S, both of which are lower than its five year historical average P/B and P/S of 1.8 and 2.2 respectively. There's huge upside potential to be had here and the stock could easily double again, as commodity prices recover. If you're a contrarian investor then buy Encana and collect its 2.1% dividend yield while you wait for the stock to rebound to new highs.
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.