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Why Investors Should Avoid Encana

Encana Corp (TSX: ECA)(NYSE: ECA) is a natural gas behemoth but the new CEO, Doug Suttles, is trying to turn it into an oil and gas-liquids company.

As Canada’s largest natural gas producer, Encana has struggled with low natural gas prices caused by the massive boom in shale-gas production. Under pressure to deliver better short-term results, management decided last fall to radically overhaul the company.

I think this decision was made at exactly the wrong time.

In November 2013, the company announced a 20% reduction in staff and slashed its annual dividend from $0.84 to $0.28 in a major strategy shift.

Encana has since sold off large natural gas assets and made big bets, purchasing oil and natural gas liquids properties in an effort to boost earnings.

Improvements in technology have created a boom in natural gas production from shale formations. This development has greatly increased the natural gas reserves in the U.S. and forced natural gas prices so low that many producers can’t compete.

This chart shows the dramatic rise in U.S. shale-gas production:

Monthly dry shale gas production.
Source: EIA

New York Mercantile Exchange natural gas prices bottomed out around $2 per million Btu in 2012, but have since recovered and recently peaked around $4.80/MMBtu in late April 2014.

Encana’s Q1 2014 earnings report came in with stellar results. Management credited this success to the new strategy, but the positive outcome was, ironically, driven by the surge in natural gas prices caused by one of the coldest winters on record. A large part of the Q1 gains, $395 million in operating cash flows, came from the Deep Panuke offshore gas facility. Now the company is considering selling Deep Panuke because this asset doesn’t fit with its new strategy.

Why I think investors should avoid buying Encana

After the dividend cut and the announcement of the new strategic plan, investors started to shift back into the stock, but the spike in natural gas prices, not the transition to oil and gas liquids, was the main reason for the jump in the price of Encana’s shares during the first half of 2014.

Short-term weakness

Lower demand from electricity companies and increased gas production are resulting in a regrowth of gas storage. Natural gas prices are on the slide, recently dropping below $4.00/MMBtu for the first time this year, and Encana’s shares are tagging along for the ride.

Encana still gets 90% of its revenue from natural gas and prices will likely continue to trend lower in the short term. If we get a mild winter in 2015, the price of natural gas could retest the lows of the past couple of years and Encana’s share price will follow it down.

Although the short-term environment looks rough, I believe the long-term outlook for natural gas is quite positive and Encana is dumping great natural gas assets at the precise time it should be acquiring more.

Long transition time

My concern is that Encana’s transition is going to take too long, and by the time it is completed, oil prices will be weak due to an oversupply of North American oil. Also, natural gas prices will be hitting new highs because the liquefied natural gas facilities being built to send natural gas to Asia will all be operational.

Long-term gas strength

The use of natural gas to generate electricity in the U.S. will continue to increase. In fact, the government is considering using natural gas rather than nuclear reactors for new electricity plants. In the coming decade we could also see natural gas being used to fuel North America’s enormous fleets of transport trucks.

I think the new management team at Encana is focusing too much on short-term market conditions and might be penalizing long-term investors by selling off valuable natural gas assets.

If management can change directions fast enough, Encana might do OK. Nonetheless, my opinion is that the wisdom of the new strategy is unclear and investors should avoid the stock.

This energy company might be a better bet

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Fool contributor Andrew Walker has no position in any stocks mentioned.

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