Encana has been under fire from the investment community for some time now. In the past I’ve been critical of the pressure public companies have to suffer nowadays (see past posts on short selling, a short term obsession with ‘growth‘ etc.) and this company is subject to plenty of pressure.
Analysts have been critical of management’s apparent ‘lack of focus.’ I’d argue that Encana’s senior management is doing a great job of pretending to be sensitive to armchair critics while in fact remaining pretty focused. There are also lessons to be garnered from their plight – worthy of a business school case. Where to begin? Let’s recall that Encana made a bold (would make a contrarian proud) strategic statement almost a couple of years ago that it would concentrate it’s efforts on the natural gas market – unquestionably its key strength. Here’s a quote from a recent newspaper article suggesting the company appears to be backpedaling:
Mr. Eresman changed his view on the company’s growth prospects in April, when be backed away from plans to double production in five years, announced just a year prior. The company made the original forecast expecting the benchmark natural gas price to hover around $6.50 per 1000 cubic feet (mcf), tested its ability to succeed if gas fell to $5 per mcf, but gas now trades around $3.60 per mcf.
The decision to go “all in” with natural gas as its primary focus was made back at a time when gas prices were almost double where they are now. Foolhardy? Be an investment analyst long enough and you’ll learn all major decisions made by large companies are ill-timed, but not necessarily bad decisions over the long life of a corporate entity. Timing is a function of the climate influencing both senior management and the Board of Directors; they’re just people afterall. Like everyone who’s neck is on the line, they are especially unlikely to approve large capital spending plans or costly aquisitions unless everything at that precise moment in time looks so rosy there’s little risk of being seen as a dufus. But when enthusiasm isn’t partially reigned in, usually by a strong and experienced Chairman or CFO, really big bonehead aquisitions and expensive initiatives can also take place at times like these and often end up destroying companies.
No decision-makers can be totally oblivious to the pevailing mood and consensus expectations, especially when they are excessively optimistic. Did anyone at that time really believe natural gas prices would fall below $5.00? A tiny minority perhaps! The company’s sensitivity analysis (i.e. “What if we’re wrong about our price forecast?”) was therefore biased by this general optimism. But as natural gas prices surprisingly declined more than forecast, the decision to backoff those aggressive production targets, despite public pressure to grow, was exactly what the doctor ordered….not a ‘lack of focus.’
The tendency to underestimate the downside is endemic – as a former founder and CEO of a public mutual fund company with a strong commitment to junior resource companies, I can tell you we (the Board, other senior management) never expected the TSX Venture stocks to plummet 70% and resource sectors even more during the financial crisis. If the assets we were managing had fallen by just half that amount (our own downside threshold) we wouldn’t have had to sell the business at a rock bottom price. The rapid rebound in these Venture listed stocks in 2009 would have skated us onside, but like with so many businesses, stakeholders lack patience and are prone to panic.
As RIMM and many other companies discover at their own pace, the outside world is the wild card. Succumbing to pressure to follow trends is sometimes unavoidable; like Research in Motion’s introduction of the Playbook – can you imagine the Board of Directors a year ago agreeing that even though Apple’s iPad is brilliant, and a huge growth area BUT deciding – ‘Hey, we’re in a different business (secure enterprise and retail communication technology and devices) and shouldn’t get involved in tablets. How could they responsibly ignore the analysts, shareholders, bankers and journalists reminding the company every day that they’re no longer in the game but are becoming an industry laggard? The company was compelled to give it a try. Surely someone asked the question: “What if the company doesn’t sell any Playbooks?” It would have been a consideration, but group think would have ensured it was a ‘minor’ consideration.
But I digress. Encana has a shareholder base that likes it’s relative stability (and strong cashflow) but like all companies still needs to find growth. The deal with the Chinese had to be explored – because of Encana being a public company it’s necessary to play lipservice to pressure no matter that it is a quantum waste of shareholder money. It had to appear sensitive to public pressure on the one hand, and on the other hand, by publicly avoiding a deal that would’ve eventually meant the loss of operating control of its assets, it actually acted in the best interests of its shareholders. The fact that Encana management refused to give up the farm to satisfy the blowhards (“make global deals” “crystallize value”) is evidence of a job capably done.
Will Encana’s focus bear fruit? A number of outside influences have proved to be stumbling blocks for sure. I put together the below chart to illustrate the most basic dynamics normally relevant to me (the ‘simple-minded’).
Following a recessionary slowdown, natural gas consumption in the U.S. has resumed growing. This is hardly surprising as oil prices remain an outrageously-priced source of energy and coal has been waning for obvious reasons. But why then has the price for natural gas in North America been falling?
Apart from structural (deliverability constraints) and other issues (crazy local protests) which tend to occasionally distort this unusual commodity, there’s this from the Energy Information Administration:
“A common misconception about natural gas is that we are running out, and quickly. However, this couldn’t be further from the truth. Many people believe that price spikes, such as were seen in the 1970’s, and in the early to mid-2000s, indicate that we are running out of natural gas. The two aforementioned periods of high prices were not caused by waning natural gas resources – rather, there were other forces at work in the marketplace. In fact, there is a vast amount of natural gas estimated to still be in the ground.”
To some extent, the rapid exploitation of oil shale deposits has indeed provided an unexpected boost to gas production in North America. Much of this supply is a result of rapid development funded by conventional energy revenues and government incentives – sort of like electric vehicle research being paid for by a combination of gasoline-powered vehicle revenues and government grants.
What’s missing in the big picture? Economics! Is shale gas actually profitable? I’m not an industry pundit, but my guess is shale gas production is heavily subsidized and the additional supply puts considerable short term pressure on conventional gas prices – at least until demand has risen enough to absorb the added supply. A healthy economic recovery in the U.S. might provide a lift to demand, and for now the downside in pricing has very likely run its course. After all, if Encana considers prices too low to grow production, and we know other companies have already shut in many of their wells…then the risk of a spike in pricing due to a sudden dirth of supply becomes more and more probable.
What’s all the fuss about LNG? (Liquified Natural Gas). Here’s a recent quote:
Ras Laffan Liquefied Natural Gas Co. will supply 8.3 million metric tons of LNG to South Korea this year, meeting a quarter of the country’s demand for the fuel, The Gulf Times reported, citing Qatar’s energy minister. Record Japanese imports to replace nuclear power after the Fukushima Dai-Ichi disaster, plus a 27 percent jump in China’s first-half purchases, may send prices to about $20 per million British thermal units this winter, up 71 percent from 2010 and the highest since 2008, according to data compiled by Bloomberg.
There’s an immediate need in parts of the world for LNG explaining the huge price premium to conventional natural gas. My prediction is simple…those prices will fall as energy needs in Asia stabilize, and domestic prices will rise as demand in North America increases. Encana management has acknowledged some “interest” in LNG market developments (lipservice?) but reading between the lines the CEO would rather not chase the latest fad. They’ve indicated they’d like exploration partners (other than China) to help share the burden of risk – since there’s pressure to grow the business and why not mitigate as much risk as is prudent. Focus has not been compromised and until natural gas pricing improves there’s plenty of cashflow to satisfy the more conservative element in their shareholder base.
So what’s wrong with this picture?
A management team making the right decisions despite all the pressure
A Dividend Yield of almost 4%
If they report “in line” on Thursday, the stock is a reasonable 5X cashflow.
I’m liking the risk/return potential of this one, and hats off to management for sticking to their guns. And if you’ve read this far…I need a job!
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