Saturday, October 15, 2011

Encana - Getting Cheap

Today I want to highlight a fantastic business that is definitely cheap.  Encana was at one time the largest natural gas (NG) company in North America.  Encana was formed back in 2002 by the merger of Pan Canadian and Alberta Energy Company (AEC).  In 2009 they spun off Cenovus which contained the conventional oil, oil sands, and the mature NG assets.  Encana kept all of the best NG assets and pushed forward to become a senior high growth focused NG company. 

Over the past three months the stock has sold off 27%.  What really caught my eye was the $1.4 million of insider buying since August 1st with no insider sales in the past year. 

So what makes Encana a compelling investment today?  I believe it's twofold.  First the company is selling for less than book value and tangible book value.  Secondly, natural gas prices are at multi-year lows leaving the opportunity for very materially asset valuation increases if gas prices increase. 

Some may find it crazy that I mention book value and tangible book value with respect to a resource company.  True, it doesn't serve any purpose or tell us if the assets the company are worth anything, but it does tell us how much equity capital the owners have in the business today.  Today you can purchase Encana for less than the equity that the owners have employed in the business.  The market is saying the assets developed with that capital isn't worth what they paid. 

While on the topic of the balance sheet, it is also interesting to note that shareholder's equity is predominately retained earnings (84%) with the remainder being shareholder (paid in) capital (14%).  Encana essentially started with $2.3 billion in shareholder's capital and has been very successful exploring and developing assets.  The accumulated profits on their investments have been $14.2 billion (all figures US$).  I don't look highly at a company that grows buy issuing more and more overpriced equity and have little to nothing to show for profits.  Good examples would be Crescent Point (CPG) and Petrobakken (PBN).  They are really exploiting ignorant shareholders who don't know better and listen to the investment houses who peddle their shares.  Despite record oil prices over the past 7 years CPG has an accumulated deficit of $1.7 billion.  I honestly think both of these company's employ a high dividend policy to keep the share price high and play the equity issuance game.  With Crescent Point, investors should be aware they are not being paid out of profits but from new shareholders.  It's return of capital, not return on capital... big difference.  It's almost like a legalized ponzy scheme.  It appears that PBN downfall has been it's operational problems in Southern Saskatchewan.  What will eventually take down CPG?  I believe a large and sustained drop in oil prices will likely be it's downfall. 

(I'm probably going to have to hide from the upcoming assault from CPG and PBN shareholders for those comments).  Let's get back to our Encana discussion. 

Natural Gas Prices

The single largest driver of the profits and associated investment returns at Encana will be the price of NG.  Here is a chart of Henry Hub NG prices ($US/MMBTU)

It's easy to see NG is a good investment today as the price is at multi year lows.  Prices haven't been this low since 2002.  Just for the sake of curiosity here is the price of West Texas Intermediate ($US/Bbl).

Now you don't have to be a rocket scientist to see what is wrong with that picture.  If you believe it's a "new era" or "it's different this time" go ahead and think so.  It may be different this time but that just isn't a risk I would touch with a ten foot pole.  The oil business has been boom to bust for the past century and like the bumper sticker says, "Please God, just give me one more oil boom.  I promise not to blow it next time."  Graphs like the one above shouldn't just scare you it should cause you to run in the opposite direction. 

The Chinese consume 10% of the worlds oil production and if you add up all of the oil used in the mining and materials industries it's a lot more.  Those industries are currently supporting the housing bubble over there, let's just say demand has the potential to fall significantly.  As Jim Chanos has said, "China is Dubia times 1000."

Wow, I'm really getting off topic today...  Back to Encana.

Encana's Asset Valuation

If you take the net present value of the 2P reserves, subtract long term debt and working capital deficiency, add a portion of the exploration and evaluation assets, and finally divide by the diluted shares outstanding...  I come up an asset value of US$34.20/shr ($US, before taxes, discounted at 10%).  This compares favorable to the current US$20/shr market price (40% discount) and is likely a good reason why insiders are buying the shares.  Encana's NG assets are very high quality and generally low cost to both find and operate.  The prices used the the discounted cash flow (a key assumption), range from just over US$4.39/MMBTU increasing to US$6.00/MMBTU in 2015.  These are reasonable price assumptions.  Futures for November delivery is US$3.70/MMBTU. 

Let me put that analysis a different way.  If you purchased the entire company and only developed the current drilling inventory and then went into blowdown mode, you would earn roughly 12% on your investment after corporate taxes (16% before tax).  If NG prices rise, these returns would be much, much higher. 


In conclusion it appears that Encana seems to be a very reasonable investment at the current price.  The company is selling for less than book value, tangible book value, and much lower than net asset value.  The current share price of US$20/shr is a 40% discount to net asset value (2P, before taxes, discounted at 10%).  Natural gas is currently selling for multi-year lows and offer good upside if NG prices increase.  This gives an investor a good margin of safety against falling commodity prices, especially when compared to oil. 

I believe this a case where the baby is being tossed out with the bathwater.  Many commodity companies are selling off.  The major drop in the XEG index is a belief that oil prices will fall.  It appears the NG industry is falling alongside Oil and Mining sectors.  The only difference is NG prices are already at the bottom while commodities like Oil, Copper, Gold and Iron are all still ridiculously priced (think bubble).  This means Encana may still fall further, but the further it does more of an opportunity it will become.  In the long term Encana will do fine, in the short term the share price may be volatile.

Encana has a proven management team and has strong technical knowledge in the exploration and development of NG assets.  This has been clearly demonstrated in the profitability of the company.  Encana has some of the best assets in the industry.  Management is very focused on generating high returns on capital. 

Best Regards,

Disclosure - none

1 comment:

  1. "The prices used the the discounted cash flow (a key assumption), range from just over US$4.39/MMBTU increasing to US$6.00/MMBTU in 2015. These are reasonable price assumptions. Spot Price for November delivery is US$3.70/MMBTU."

    Q: How is that price range consistent with current strip?
    A: It's not. This throws your entire argument (that ECA is cheap on a NPV basis) out of the window. Man, you're not very intellectually honest, are you?