EnCana (OP/A): Resource remains strong, returns remain key question - Goldman Sachs - October 27, 2005
EnCana's 2006 outlook is at least temporarily disappointing due to rising capex (15%) relative to production (7%), though EnCana is likely not alone in seeing rising service cost pressures. This could put further upward pressure on natural gas prices in 2006, which is in part why we recommend gas-focused E&Ps into this winter. We believe EnCana has premier unconventional gas assets and that its Nov. analyst meetings could be a catalyst. Noise has increased due to the '06 outlook, M&A rumors and the coming departure of CEO Gwyn Morgan. Among visible growth large cap E&Ps (XTO, ECA, CHK, EOG), XTO is our top pick, and we find it difficult to choose among the remainder. We rate EnCana OP/A for now. If the meeting does not boost expectations/valuation of assets in the Piceance Basin and new Rockies discoveries, we would feel even more forceful in our preference for companies in East Texas and the Mid-Continent relative to Rockies peers.
COST INFLATION: LIKELY NOT AN ENCANA-ONLY ISSUE, THOUGH ENCANA'S NEAR-TERM RETURNS ARE SUBPAR
EnCana expects 2006 E&P capital spending of $6.2-$6.5 billion, about 15% greater than the $5.4-$5.6 billion expected during 2005. While the idea that rig costs are rising, the ability to execute large drilling programs has been slowed due to rig availability, rig quality and permitting are not new issues, they become more tangible when the largest E&P matches 15% increases in spending with a 5%-9% increase in projected growth. We were assuming double-digit production growth and similar levels of spending. EnCana has historically shown returns below industry peers, though clouded somewhat by acquisitions, divestitures and a low-return midstream business. Few companies have put out guidance for 2006, though we suspect EnCana will not be alone in seeing cost inflation and increased competition for service equipment impact 2006 production growth potential. EnCana caused similar consternation a year ago when it announced it was moderating growth and spending what was regarded as high levels of capital spending. EnCana eventually got back into favor with the Street, although the company then was a bit more forceful regarding share buybacks.
IF AN INDUSTRY ISSUE, WE SEE UPWARD PRESSURE ON NATURAL GAS PRICES
Greater competition for drilling rigs, rising rig rates and lower rig and rig crew quality could put downward pressure on 2006 North American natural gas production and upward pressure on natural gas prices. As we detailed in our October 24, 2005 report, "Gas E&Ps favored with winter looming", we believe consensus 2006 natural gas prices are too low and equity valuations, thanks to the recent pullback, are almost assuming a warm winter. We are assuming $10 per MMBtu for Henry Hub natural gas and $68 per barrel for WTI crude in 2006, and our EPS estimates for E&Ps are 25% above consensus.
WE STILL SEE ANALYST MEETING AS A CATALYST...
We continue to believe that EnCana has a high-quality position in almost all of the top Rockies and East Texas unconventional gas basins. We continue to believe that the company will highlight its resource potential at its analyst meetings on Nov. 7 (Calgary) and Nov. 9 (New York), which could be a catalyst for the stock. We continue to believe the company has far more recoverable resource in the Piceance Basin than is in its current unbooked resource potential guidance, that there are positive developments that could increase recoverable resource in the Jonah field and that exploratory success in British Columbia's Cutbank Doig field is positive and not factored into the stock.
... THOUGH OTHER NOISE IS GETTING LOUDER
However, enough has gone on at EnCana over the last month that has the potential to cloud positive momentum on EnCana's resource base which we believe will come out of the company's analyst meeting:
(1) Back and forth rumors regarding potential consolidation involving EnCana.
(2) The surprising announcement of the departure of CEO Gwyn Morgan at yearend.
(3) The October 26 earnings/guidance disappointment that could cause a requestioning of to what extent EnCana's superior resource base should trump its at-least-temporarily below-average returns.
WE BELIEVE THE STOCK IS OVERSOLD, THOUGH OTHER VISIBLE GROWTH PEERS ARE ATTRACTIVE
We continue to rate EnCana Outperform and would own the stock heading into the company's analyst meeting. We believe yesterday's selloff was overdone, even if we were to assume the inflationary factors solely impact EnCana. Among visible growth large cap E&Ps (XTO, ECA, CHK, EOG), XTO is our top pick, and we find it difficult to choose among the remainder. EnCana and Chesapeake are both hedged to a greater degree than EOG and XTO Energy (OP/A). To the extent that the analyst meeting does not boost expectations and valuation of assets in the Piceance Basin and new discoveries in the Rockies, we would feel even more forceful in our view that exposure to companies in East Texas and the Mid-Continent is preferred going into winter relative to companies in the Rockies.
3Q 2005 RESULTS BELOW EXPECTATIONS
EnCana reported 3Q 2005 operating and financial results generally below expectations. Adjusted EPS of $0.92 was below our estimate of $1.00 (when excluding Ecuador operations), while reported EPS, including special items and excluding Ecuador, was $0.30. Operating cash flow of $1.93 billion was in line with our estimate, while production of 4.0 Bcfe/d was below our estimate of 4.2 Bcfe/d. All-in unit costs were $3.54 per Mcfe versus our estimate of $3.48 per Mcfe. Commodity price realizations were $45.16 per barrel for North American oil and $7.29 per Mcf for natural gas versus our estimates of $38.75 per barrel and $7.62 per Mcf, respectively. Net debt/tangible capital rose to 42% at quarter-end from 38% at the end of 2Q 2005, though we believe this is temporarily high due to depressed equity/working capital relating to mark-to-market hedging activity.
UPDATING ESTIMATES
We are lowering our quarterly 2005 and full-year 2006-2010 EPS estimates to reflect revised assumptions for production, realized commodity prices, unit costs, the effects of asset sales, and minor other adjustments. Our 4Q 2005 EPS estimate is now $1.54 ($1.61 before), and our full-year 2005 EPS estimate is now $3.90 ($4.17 before). For 2006, we now estimate EPS of $4.77 ($5.19 before), and for 2007 we now estimate EPS of $5.85 ($6.08 before). Our 2008-2010 (normalized) EPS estimates are now $2.03 for 2008 ($2.13 before), $2.17 for 2009 ($2.25 before), and $2.30 for 2010 ($2.37 before).
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Brian Singer, Arjun Murti. |
