Encana Reaps Benefits of Transformation
The company emerges from a transitional year with an exceptional asset portfolio.
Encana (ECA) has transformed itself in the past year and a half, and its future is now solidly underpinned by cost-advantaged growth. This is a radical shift from the past, when the company was a lower-margin natural gas producer. Our $16 (CAD 19) fair value estimate is predicated on our belief that commodity prices will recover during the next few years. However, Encana also is one of the most defensive upstream stocks. The firm is well hedged (60% of 2015 volumes), and its balance sheet is in good shape.
Encana's impressive asset portfolio is the product of a transformation that began 18 months ago. At that time, the firm's mix was skewed heavily toward natural gas (90% of 2013 volumes) and the bulk of that production was sourced from its Clearwater, Piceance, and Haynesville assets, which are all higher on the cost curve. Management's goal was to boost cash flows and returns by executing a positive mix shift and deploying capital on high-margin, liquids-rich assets. The company defined a core list of five liquids assets: the Montney, the Duvernay, the Denver-Julesberg Basin, the San Juan Basin, and the Tuscaloosa Marine Shale. All other assets were marked for sale.
Encana made two substantial acquisitions during 2014, gaining entry into two new oil plays (the Permian and the Eagle Ford). Relative to the company's five core plays, both compare favorably on the quality spectrum and management has subsequently defined a "core of the core" priority list, which includes both of these acquisitions as well as the Montney and the Duvernay. At least 80% of the company's 2015 capital budget will be allocated to these assets.
The combined cost of Encana's 2014 acquisitions was around $10 billion. However, management was able to fund the majority of this with asset sales. The company sold a handful of natural gas assets with mediocre economics (including the Bighorn, Clearwater, and Jonah fields and some miscellaneous acreage in East Texas). In addition, although the original intention was to retain a stake in the company's spun-off Canadian mineral rights business (PrairieSky), pricing was driven up by investor demand and Encana capitalized by selling its remaining share soon after the initial public offering. Total divestment proceeds were more than $8 billion.
Asset Reshuffle Paves the Way
Our sense is investors are still too focused on the old Encana and aren't fully appreciating how the future trajectory of the company has completely changed. Encana is already a very different company than it was a year ago. However, it's the quality of undrilled assets that has primarily (and markedly) improved--the current production base still contains a large portion of less profitable legacy gas production. Last year's portfolio upgrades will dramatically improve the mix, but that will take time. Encana's liquids weighting has already improved to 80% from 90%, but it won't approach 50% until 2018-19.
Tactical Spending, Not Splurging
By more or less balancing purchases with divestments in 2014, Encana was able to maintain a strong financial position. At the end of the first quarter, the company reported around $7 billion in total debt. That's 43% of total capital, which is at the lower of the spectrum among North American exploration and production firms. Likewise, net debt/trailing EBITDA is currently 1.7 times, comparing favorably with peers. Preserving credit ratings is a high priority for this company, and we expect leverage to be managed conservatively.
Don't Rule Out Future Acquisitions
We believe Encana's spending will be fairly balanced with cash flows after 2015, although declining production from the company's legacy assets will prevent much production growth in the next several years. Therefore, we'd prefer to see management preserve the war chest rather than continue the shopping spree.
However, it's a buyer's market. Therefore, we wouldn't be surprised if the company announced one or two incremental deals in 2015-16; realistically, these would need to be paid for by monetizing current properties. There's plenty of scope for this--the company has seven core holdings currently but is really only developing four of them. In addition, Encana's legacy gas positions, especially the Piceance and the Haynesville, might be a better fit elsewhere.
Therefore, 2015 could end up being an extension of 2014 in terms of asset-swapping. Further acquisitions could be value-destructive, but only if the company overpays, and in 2014 this management team established a solid record for prudence and selectivity. We'd tentatively support more of the same but would pay close attention to the impact on the balance sheet.
Dissecting Encana's Impressive Asset Portfolio
Encana's narrow economic moat rating stems from its substantial acreage holdings in multiple low-cost, high-margin resource plays in Canada and the United States. This year Encana will allocate 80% of its capital to the four liquids-rich plays that management expects to offer the biggest bang for the buck: the Permian Basin and the Eagle Ford Shale in Texas and the Duvernay and Montney shales in Canada. The company also recognizes upside potential from its properties in the San Juan and DJ basins and from the TMS. However this latter group is in an earlier stage of the development cycle--drilling results to date have been successful, but developing the core plays clearly takes precedence over the delineation of these emerging plays while oil prices are low.
High-Quality 'Core of the Core' Assets Drive Narrow Moat Rating
With a return to $100/barrel oil looking unlikely in the coming years, cost advantage is a more crucial differentiator than ever for E&Ps. This is governed primarily by geography and geology. In addition, while the North American benchmarks for oil and natural gas prices are driven by macroeconomic factors, local pricing can vary substantially as a result of takeaway capacity constraints or transport costs for production in remote regions.
The bottom line is that E&P returns are driven largely by the quality of the firm's acreage, and Encana has assembled a very competitive portfolio. Despite our reduced commodity price forecasts, wells drilled in the company's four primary acreage areas will yield healthy returns in the 20%-40% ballpark. Returns at the corporate level will be more moderate because of the inclusion of taxes and the commingling of cash flows with those from Encana's legacy assets (which still represent a substantial portion of the company's operating income). However, activity in these focus plays will be ramping throughout our five-year forecast window. We project steadily improving returns during this period and anticipate sustained excess returns in the harvest phase, supporting our narrow moat rating.
Our estimated break-evens for the core-of-the-core assets range from $36 to $49 for the West Texas Intermediate benchmark, signaling a stronger-than-average cost position in the E&P space. That also suggests a reasonable cushion of safety from current prices (WTI is trading for $59/barrel in the spot market). It is encouraging to note that Encana has value-adding dry powder to drill, even if prices recover more slowly than the market is anticipating. However, the critical point is that all four of these core-of-the-core plays break even well below our new WTI midcycle price estimate of $69/barrel. As a result, we believe Encana can look forward to strengthening returns on invested capital over the cycle, as these assets play an increasingly pivotal role in the company's operations.
Encana's drilling inventory is huge relative to the current pace of activity (and we're just focusing on the core of the core--the company has many economic locations elsewhere as well). In any reasonable scenario, there's a 10-year-plus runway before running out of high-quality acreage to drill in the Permian, the Montney, and the Duvernay.
Following the lowering of our oil and gas midcycle price forecasts, Encana is still set to be one of the winners in a lower commodity price environment. Encana's core-of-the-core assets are its most attractive in terms of potential returns and break-evens, and its inventory is deep enough to leave room for greatly accelerated activity if oil prices recover, or for many years of harvesting at the current pace. In our valuation, these assets represent 59% of our estimate of the company's enterprise value ($13 per share). This proportion will grow over time as capital is poured into these assets to stimulate production growth while the rest of Encana's portfolio experiences natural field declines.
Much of the remainder of our valuation is derived from the three assets (TMS, the DJ Basin, and San Juan) that don't make the cut for inclusion in management's core of the core. Each of these has attractive economics and originally was considered a priority before Encana's purchase of the Permian and the Eagle Ford.
We base our fair value estimate on a net asset value buildup of Encana's assets. Our valuation is predicated on our expectation that commodity prices recover in the coming years: Our pricing forecasts assume three years of strip prices with terminal prices set by our midcycle assumptions of $69/barrel WTI and $4 per thousand cubic feet Henry Hub.
For each shale play, we project single-well cash flows, aggregating these cash flows according to our expectations for future development activity. Our model includes adjustments for additional components of value, including the mark-to-market value of the company's hedge book, previously announced but as-yet-uncompleted acquisitions and divestitures, and its recent equity issuance.
Dave Meats does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.