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3 Things to Like About Encana’s Results, and 1 Thing to Worry About

Encana’s (TSX: ECA)(NYSE: ECA) second-quarter results were very positive and reflected the steady progress on the company’s turnaround, which is progressing faster than expected. Listed below are three things that investors should like about the second-quarter earnings and one thing that could keep them up at night.

What to like

1. Strong liquids production growth: While total production declined 3% due to the assets that Encana sold this year, liquids production is growing faster than the company’s expectations. Second-quarter oil production showed an increase of 43% versus the same period last year. Natural gas production decreased 8% to 2.54 billion cubic feet (bcf).

Natural gas still makes up a big part of production at 86%. In the second quarter last year, natural gas accounted for 90% of production. With the sales of its natural gas assets and the focus on liquids continuing, this will keep on declining. In fact, Encana anticipates that by 2017, 75% of its cash flow will be generated from its liquids production.

2. Increased guidance: Management increased its cash flow guidance to $3.4 billion to $3.6 billion, up from $2.9 billion to $3 billion. Expectations for liquids production were also increased, to 86,000 bbls/d to 91,000 bbls/d, up from previous guidance of 68,000 bbls/d to 73,000 bbls/d.

3. Ample cash on the balance sheet: At the end of the second quarter, Encana had $2.7 billion in cash on its balance sheet. Additionally, long-term debt has decreased by $1.5 billion. On the conference call, the company did not say what it plans to do with this cash, citing the obvious options such as debt repayment, asset purchases, and/or giving money back to shareholders in some way. Either way, this is obviously a good position to be in.

What could go wrong?

There is a growing concern in the back of my mind that Encana is moving away from natural gas toward oil production at the worst possible time. Oil is trading at highs and natural gas is trading at lows.

The problem is twofold. First is the price that the company is getting for their natural gas asset sales. Since these sales are being done at a time when natural gas is trading at depressed levels and sentiment on the commodity is negative, these assets are being sold for less than what they are probably worth if we consider the full cycle. Second, if natural gas will, in fact, outperform oil going forward as I believe it will, then Encana is once again making a decision that is backward-looking as opposed to forward-looking.

I keep flashing back to the early 2000s, when natural gas was trading at record highs and there was nothing but optimism toward the commodity. At that time Encana transformed itself into a natural gas producer, spinning off its oil production into Cenovus. The company’s decision to focus on natural gas was the epitome of bad timing, as natural gas prices proceeded to head south shortly after that decision, falling to lows of just over $2 from a high of over $13 back in 2008.

Encana still has Haynesville, a high-quality natural gas asset, but as we know, the company has sold off other big, high-quality natural gas assets, such as Bighorn, which was sold for $1.8 billion. According to some analysts, this asset is worth much more, and the price paid should have been closer to $2 billion to $2.5 billion. The Bighorn asset has about 1,100 billion cubic feet of reserves, with natural gas representing 75% of it.

The bottom line

In the short term, Encana is doing the right thing for its financial performance. However, there is a situation looming that could make investors question the company’s recent strategy. Encana has been giving up some high-quality natural gas assets at less than impressive prices and in a cyclical business, it is much better in the long term to make decisions that are counter-cyclical.

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Fool contributor Karen Thomas owns shares of EnCana.

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