After posting impressive second-quarter results last month, shares of Encana Corporation (TSX:ECA)(NYSE:ECA) have continued higher towards $9 a share–a considerable jump from this year’s lows of about $3 a share.
Higher selling prices and lower costs help the company turn a surprise net operating profit in the second quarter. Of considerable impact, drilling and completion costs across its four core assets are now more than 30% lower than the 2015 average. Another $100 million reduction in transportation, processing, and operating costs are expected by the end of the year. While these impressive gains have been achieved, natural gas prices have popped by nearly 20% since the year began.
It seems as if everything is going right for Encana. How likely is it that things will remain rosy?
A transition that is paying off
While rising natural gas prices are now helping the bottom line, Encana’s management team is still set on diversifying the company’s revenues away from that single commodity. Over the last few years Encana has focused on boosting its oil production, which typically comes with higher selling margins along with a better macroeconomic backdrop. In just three years oil has grown from 5% of production to nearly 20%.
Already, 96% of Encana’s capital expenditures are dedicated to its four core properties. In the second quarter a record-high 73% of production came from its top four regions located in the Permian, Eagle Ford, Duvernay, and Montney basins. Because those properties are largely oil producing, Encana’s output should slowly shift away from natural gas.
Generating a surprise operating profit (partly due to rising natural gas prices) will actually help the company quicken its transition towards oil. Along with its latest results, Encana management also revealed that it would boost this year’s capital expenditure program by $200 million, bringing the overall budget to $1.1-1.2 billion from under $1 billion. Higher capital expenditures in its core properties will result in oil boosting its share of Encana’s output mix. By 2018 natural gas will likely comprise less than 50% of production, down from 82% in 2014.
Not so fast
While Encana has proven its ability to both survive and navigate the current low-price environment, its transition towards oil is still years away. Encana will remain predominantly natural gas until at least 2018. With North American natural gas production remaining elevated and rising oil prices creating incentives for forced natural gas sales, prices for that commodity likely won’t continue their impressive run for long. LNG exports to Asia or Europe is a long-term tailwind, but that is also still years away.
While the transition continues, the company will still face difficulties with its mounting debts. Encana’s long-term debt stood at $5.7 billion at June 30, having increased from $5.3 billion on December 31, 2015. A widespread hedging program improves visibility a bit, but if you were interested in playing Encana’s momentum, remember that this story still has years left to fully play out. For now, Encana remains an option for long-term investors only.
