Analysis: Clock ticking for Canada's natural gas champion

Encana Corp Chief Executive Randy Eresman did exactly what investors wanted when he created the quintessential pure play in North American natural gas. That's now his biggest problem.

The outlook for gas prices has darkened, due in part to success Encana and its peers have had unlocking vast shale reserves close to major markets, and that has forced Eresman to revise his game plan frequently.

Canada's biggest gas producer has clawed back its long-term production target, put assets on the block and now looks poised to 2012 chop spending to keep already-high debt from getting out of hand. Its share price has fallen in response.

Now some investors wonder how long the company, designed to squeeze increasing volumes of gas out of stubborn rocks, can meet its initial promise.

My view on Encana is that they're running out of room, said Jim Hall, chairman of Mawer Investment Management Ltd, which holds more than 700,000 Encana shares, according to Thomson Reuters data.

Their balance sheet can't withstand gas prices at these levels forever and their asset sales reflect this reality. The assets themselves will be fine but it's an open question as to whether Encana will still own them when the gas price eventually moves higher.

Encana reinvented itself as a pure gas play with the spinoff of its oil sands assets into Cenovus Energy Inc in late 2009. Now a proxy for the gas industry, it produces the fuel at fields stretching from Louisiana to northern British Columbia.

It is a big promoter of expanding gas use into export and transport, and has mounted a campaign to impress upon the public that it is protecting ground water as controversy over hydraulic fracturing - the method used to extract gas from shale - has flared.

At Wednesday's close of C$23.26 on the Toronto Stock Exchange, the stock has skidded 22 percent in the past year, compared with a 4 percent drop for the TSX oil and gas group.

MURKY LONG-TERM PICTURE

Analysts say higher gas prices hold the biggest short-term potential for increases. Longer-term, the picture is murkier.

On one hand, it's hard to argue with Encana's strides making drilling and hydraulic rock fracturing more efficient and less costly, turning its Cutbank Ridge, British Columbia; Jonah, Wyoming; and Haynesville, Louisiana, fields into near assembly lines.

But even with costs falling, gas markets have not offered incentive for big jumps in capital spending to boost output.

At the time of the Cenovus spinoff, gas was above $5.50 per million British thermal units. It has since fallen to around $4 per mmBtu, a level at which Eresman has said Encana can still make money.

A Reuters poll of 27 gas price forecasters in July showed most do not see a return to the $5.50 level in 2012 and several don't expect it in 2013 either.

Last spring, Eresman tempered his five-year target to double production, about one year after he announced it, blaming the persistently weak gas market. Encana cut its long-term price outlook to $6 per mmBtu from a range of $6-$7.

Current plans call for output of about 3.5 billion cubic feet a day equivalent in 2011, up about 6 percent from 2010.

LIVING WITHIN MEANS

At the same time Encana has overspent its cash flow on operations to lift output and acquire lands in regions offering the potential for prospects with a larger proportion of more valuable oil or condensates.

That has pushed debt to about 2 times annual cash flow, a level both the company and its investors see as uncomfortably high. Last week, Encana said it will keep spending and dividends equal to cash flow in 2012.

Encana's assessment of how weak natural gas prices would be was wrong and that influenced their strategy. They were chasing dry gas at a time when others were chasing liquids, Michael Dunn, analyst with FirstEnergy Capital Corp said.

Liquids, or gas with high volumes of oil or condensates were an early target for companies such as Chesapeake Energy and EOG Resources in plays like the Eagle Ford in South Texas and Bakken in Saskatchewan and North Dakota.

Encana has recently amassed acreage of liquids-rich shale prospects including the Duvernay in Alberta and Collingwood in Michigan. But it will take at least a year for such plays to prove themselves to be solid producers.

It targets up to $2 billion of asset sales this year. It struck two deals to jettison gas pipeline and processing assets in Colorado for a total of $900 million and put its Barnett Shale interests in Texas on the block.

A big question now is whether the sales will start to eat into Encana's future prospects. With 11.7 million net acres of established plays and huge reserves, that time is a long way off, said Garey Aitken, chief investment officer at Bissett Investment Management Ltd, which holds 1.3 million shares.

Aitken said he supports the moves to ease off on growth and concentrate on the best plays while the gas price languishes.

I do think it's appropriate and consistent with their approach to high-grade their asset base and really focus on the assets and the stage of the life-cycle of those plays ... recognizing that they've got a situation here where it's appropriate that they live within their means, he said.

A top initiative is Encana's quest for joint venture partners to help develop longer-term prospects while preserving some of its own money. But that has proved to be risky.

A high-profile, C$5.4 billion joint venture with PetroChina to develop its Cutbank Ridge play fell apart in June, in an apparent dispute over value and the pace of development. Earlier, some investors had criticized Encana for giving away a stake in major producing assets.

Eresman has said a new effort to attract a partner for Cutbank has several key differences, including a decision to concentrate on mostly undeveloped parts of the play.

With the stock under pressure, the company could look attractive to larger rivals with deep pockets and patience, some analysts said.

Last year, Exxon Mobil Corp bought shale-gas producer XTO Energy for $27 billion and has since snapped up other smaller players, showing the appetite of the oil majors.

Are the management and board of Encana in the mood to sell themselves right now? Probably not, Dunn said. But the Exxons of the world, with healthy balance sheets and longer-term time horizons, are they in the mood for another large acquisition? I'm not sure but I would never rule them out.