Encana Corporation: Should This Stock Be Your Top Pick for an Oil Rebound?

Encana Corporation (TSX:ECA)(NYSE:ECA) offers big rewards on an oil rally, but significant risks remain.

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Encana Corporation (TSX:ECA)(NYSE:ECA) is being left for dead by investors, but contrarian types are looking at the stock and wondering if the potential upside is worth the risk of getting in now.

Let’s take a look to see if Encana is the best way to play a potential oil rally.

Slashing again

Encana recently reduced its dividend again and lowered the 2016 capital program by another 25%.

The annualized dividend is now set at US$0.06 per share, which will use up about US$50 million in cash. The new plan also calls for 2016 capital expenditures of US$1.5-1.7 billion, down from US$2.2 billion in 2015.

Things are getting pretty tight, so 95% of the spending will be focused on the company’s top four assets located in the Permian, Eagle Ford, Duvernay, and Montney plays with 50% of the money directed at the Permian asset. Year-over-year production from the four core assets is expected to rise 12%.

Production outlook

The four sites are expected to average 260,000–280,000 barrels of oil equivalent per day (BOE/d), representing about 75% of 2016 production. However, total output for the year is expected to be 340,000-370,000 BOE/d, significantly lower than the 2015 guidance of 395,000-430,000 BOE/d.

That is going to put a pinch on cash flows.

Balance sheet issues

Encana’s woes are largely connected to a massive debt load resulting from a few expensive acquisitions made at the top of the oil market. The company began 2015 with US$7.8 billion in long-term debt.

Management has done a good job of raising capital, selling off assets, and cutting corporate expenses to get the debt load down. The previous objective was to lower net debt by about US$3 billion by year end, but the recent delay in the closing of a US$900 million asset sale announced last spring means the target might not be hit until the second quarter of 2016.

None of the long-term debt is due before 2019, so the company has time to make more progress.

Cash flow concerns

Encana had Q3 2015 cash flow from operations of US$371 million and spent US$473 million on capital projects. That means cash flow fell short by US$102 million before the company even paid the dividend.

The reduction in the dividend and the capital plan will help close the gap, but lower production and current energy prices could put the 2016 cash flow assumption of US$1-1.2 billion at risk.

In the December 14 update, Encana said it expects WTI oil to average US$50 per barrel in 2016 and NYMEX natural gas to average US$2.75 per MMBtu.

WTI oil is currently at US$37 per barrel and natural gas is at US$2.30 per MMBtu. Natural gas is up significantly in recent days, so there could be a rally in the works, but both oil and gas will have to move much higher to hit Encana’s targets.

The company has some hedging in place to help ease the pain and support cash flow, but the picture doesn’t look great.

What’s the upside?

Encana owns a fantastic portfolio of assets located in North America’s best plays. If oil and gas can muster a rally next year the stock will surge and the move could be significant given the extent of the selloff.

Another catalyst could be a takeover bid. Encana would be a prize catch for any one of the majors that still has a strong balance sheet and the ability to ride out the slump.

At the time of writing Encana has a market cap of US$4.25 billion. If you add in expected net debt of about US$5 billion you get a potential buyout price of just over US$9 billion. If you throw in an extra $2-3 billion as a premium you still get a price that could be pulled off by the larger companies in the sector.

Should you buy?

Encana remains a risky bet. If you are convinced oil is headed higher through 2016, it might be worth a shot, but I would probably look for other opportunities.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

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

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