The promise of oil sands

Encana (ECA, NYSE)) is among the largest holders of gas and oil resource land onshore North America, and is a technical and cost leader in the in-situ recovery of oil sands bitumen. As such, and given a declining hedge book, the company offers robust leverage to rising energy prices in our opinion. Following a recent correction in oil prices, and with full year results looming, we are placing Encana on a 'traffic light' alert - with the possibility of a buying opportunity emerging in the coming weeks.

The most significant feature on Encana's charts is the broad trading range that has developed over the past three and a half months. This band of consolidation has developed in the wake of a four and a half year rally which saw the share price hit a record high of $59.82 in October. Resistance is provided by the upper end of the range at $52 while support is present at the November low of $42. With prices currently dipping below $45 we will be watching closely to see how the stock reacts to a test of the lower end of the range.

Encana was born out of the 2002 merger between PanCanadian Petroleum and Alberta Energy Company (AEC). PanCanadian's original roots go as far back as 1883 and the first natural gas discovery in Alberta. AEC meanwhile was privatised by the Government in 1975. After diversifying into a range of resource investments, AEC was rationalised during the early 1990's with the focus returning to core opportunities in oil and gas.

Today the group's strategy centres around the development of huge unconventional hydrocarbon reservoirs using large-scale drilling programs. Encana's portfolio of long-life resource plays includes 10 key properties in Canada and the United States, eight producing natural gas and two focused on oil. These unconventional resource assets typically boast low geological and commercial development risk, low average decline rates and long production lives. The use of technology to unlock resource potential is central to Encana's aim of increasing production and reserves and decreasing costs over the life of these assets.

The robustness of third quarter results released in October give us much confidence regarding the impending release of full year results next week. Third quarter operating earnings increased 33 percent on the prior year to US$704 million on the back of higher gas sales along with stronger natural gas and liquids prices. Net earnings of US$266 million for the quarter were impacted by unrealised hedge losses of US$604 million. The future earnings impact of these hedges will be less significant, with around 60 percent relating to the 2004 acquisition of energy producer Tom Brown plc, and all positions expiring at the end of 2006.

Given our bullish view on energy prices we are encouraged by the status of Encana's hedge book. This year around 82 percent of forecast sales will be fully exposed to price upside. About 80 percent of 2006 forecast gas sales and around 91 percent of oil and natural gas liquids (NGL's) sales are exposed to price upside. Encana is estimating gas sales of between 3.50 and 3.63 billion cubic feet per day (bcfd), and North American oil and NGL sales between 155,000 to 160,000 barrels of oil per day (bopd) in the year ahead.

Full year gas production next year is expected to be between 3.25 billion to 3.30 bcfd, nearly 9 percent ahead of 2005. Declining production in conventional oil properties and higher royalty rates should be mitigated by growth from expanding oil sands. Encouragingly, full year operating costs last year are forecast at 55 to 60 cents per thousand cubic feet of gas equivalent (Mcfe), which leaves Encana amongst the lowest cost operators in the industry. We believe this bodes well for earnings in the future.

Recent drilling successes at Encana include a substantial natural gas discovery in British Columbia. The 'Cutbank Doig' find is estimated to contain 350 to 550 billion cubic feet (bcf) of original gas and is now producing about 25 million cubic feet of gas per day from five wells. The find is believed to have similar characteristics to the nearby 'Sinclair Doig' which has produced more than 250 bcf since discovery in the 1970's and is expected to yield more than 400 bcf during its life.

Complementing Encana's unconventional gas strategy is a tremendous growth opportunity in Canadian oil sands. These have the potential to deliver more than a twelve-fold production increase from the current level of about 42,000 bopd to around 500,000 bopd within the next 10 years. The combination of advances in thermal extraction technologies and the strengthening of world oil prices now make the development of oil sands a viable option.

With 1.2 million acres, Encana is the largest owner of Canadian oil-sands tenements. These properties contain an estimated 40 billion barrels of original oil in place, with recoverable resources of between 5 and 10 billion barrels. The oil-sands projects, Encana believes, could translate into a growth rate of 15 to 20 percent in North American oil and natural gas liquids sales between 2006 and 2009.

Encana's industry-leading oil sands recovery teams have proven the technical capabilities of steam-assisted gravity drainage process (SAGD). Encana has received around 20 inquiries from a variety of oil companies, including major multinationals, integrated producers and national oil companies, seeking to participate in oil sands projects.

Presently, Encana is considering various business opportunities, such as possible equity investments, farm-ins, asset swaps, long-term bitumen supply agreements and the integration of upstream and downstream assets. These options would diversify earnings and reduce financial risk for the company. Capital development requirements are estimated at between $5 and $7.5 billion over the life of these projects if the 500,000 bopd target is to be reached.

The Foster Creek project, the largest and most advanced commercial SAGD project, is in the midst of doubling its planned production to an estimated 60,000 bopd by the end of 2006. The project is capable of returning more than Encana's cost of capital at an oil price of $20 per barrel. An expansion of the Christina Lake project from 7,000 to 18,000 bopd by the first quarter of 2008 has also been approved. Longer term Foster Creek and Christina Lake are expected to deliver up to 150,000 and 250,000 bopd respectively while Borealis, a new in-situ project, has the potential to reach production of 100,000 bopd.

From a balance sheet perspective Encana is in sound shape. Net debt to market capitalisation and EBITDA (earnings before interest, tax, depreciation, and amortisation) stood at 40 percent and 1.6 times respectively at the end of last quarter. Further improvements are expected (along with the potential for share buybacks) following a series of asset sales.

In November Encana sold a 50 percent interest in the Chinook heavy oil discovery offshore Brazil for around $350 million, at an after tax profit of more than $200 million. In December the majority of the natural gas liquids business was sold for $586 million - a gain of around $400 million.

We believe that Encana is strongly positioned to take advantage of an ongoing bull market in energy. The company has proven reserves (at 31/12/04) of 10.5 trillion cubic feet of natural gas and around 501 million barrels of oil. In addition the hedge book is being reduced rapidly. We also believe in the tremendous growth potential offered by the development of oil sands assets.

Whilst oil and gas prices have suffered a minor correction this week on the back of a higher than forecast build in US inventories, long-term supply demand fundamentals are supportive of higher prices in our opinion, making exploitation of these resources more than economical.

Given the positive long-term uptrend in ECA, a rebound off the US$42 region would be an encouraging sign of further gains. Should this occur we will look to make a buy recommendation in the weeks ahead. Alternately, a break above resistance at the 2nd February high of US$50 would also present a potential buy signal.

Prior to one of these scenarios eventuating, we believe the best strategy is to monitor ECA. From a fundamental perspective Encana offers sound value with a price earnings multiple around 11 times. Accordingly, we will alert Members should an appropriate buy opportunity occur in the coming weeks.

Prior to one of these scenarios eventuating, we believe the best strategy is to monitor ECA. From a fundamental perspective Encana offers sound value with a price earnings multiple around 11 times. Accordingly, we will alert Members should an appropriate buy opportunity occur in the coming weeks.