A pessimistic outlook has been weighing heavily on Canada’s third-largest natural gas producer Encana (TSX:ECA)(NYSE:ECA) for some time. Prolonged natural gas and oil slumps have weighed heavily on its performance, causing it to lose a whopping 42% over the last year. This is despite the Henry Hub benchmark spot price for natural gas 4% and the North American oil benchmark West Texas Intermediate (WTI) only losing around 13% for that period.
Why Encana is undervalued
It appears that the market has failed to appreciate the success Encana is experiencing with pivoting its portfolio to greater liquids production and bolstering its portfolio of quality low-cost U.S. petroleum assets. Then there is the US$5.5 billion all-stock acquisition of U.S. onshore upstream oil producer Newfield Exploration (NYSE:NFX), which will give that strategy a major shot in the arm and make Encana a leading North American upstream oil and gas producer.
That deal, which is expected to close during the first quarter of 2019, will not only significantly bolster Encana’s U.S. assets and production but also the volume of petroleum liquids it produces. On closing, Encana become a major player in three of North America’s top hydrocarbon plays the Permian, Anadarko, and Montney shale plays.
The market is failing to appreciate the benefits that this will deliver for the combined entity, including reducing the impact of the wide differential between Canadian oil and natural gas prices against North American benchmark prices. Encana anticipates achieving many of the forecast synergies generated by the deal during the second half of 2019. Those should see operational expenses fall while boosting production.
That comes on top of the driller having already pivoted its focus to exploiting its liquids-rich Permian and Eagle Ford acreage. Encana’s third-quarter 2018 results show that oil and other petroleum liquids production expanded by an impressive 40% year over year to 178,700 barrels daily to be responsible for 47% of its total hydrocarbon output. That notable increase in liquids production will help to reduce the impact of weaker natural gas prices on Encana’s financial performance, especially now that the fuel has pulled back sharply to trade around its lowest level in a year.
Total production from the company’s U.S. operations also expanded substantially for the quarter. The volume of oil produced by Encana’s U.S. operations for the third quarter shot up by a healthy 28% compared to a year earlier, while natural gas liquids output grew by an impressive 30% year over year. By growing production from its U.S. properties, Encana can maximize the return received on the capital required to develop those resources, because it can typically realize a higher price per barrel of oil equivalent sold compared to its Canadian assets.
This is because the oil and natural gas produced is sold at the North American WTI and Henry Hub benchmark prices rather than domestic Canadian prices, which trade at a wide differential to those prices. Currently, Canadian light and heavy crude sell at a discount of around US$3.65 and US$9.64 per barrel to WTI, respectively. The domestic AECO natural gas price of US$1.46 per million British thermal units (MMBTU) is almost half of the US$2.70 Henry Hub price.
The addition of Newfield’s low-cost U.S. operations in the Williston, Uinta, Anadarko, and Arkoma basins will not only boost earnings but margins for that reason. This — along with a range of efficiencies, including the amount of sustained and development capital for the combined business being lower than when Encana and Newfield were standalone entities — will give free cash flow a healthy lift.
Why buy Encana?
It appears that market has yet to realize the value of the combined assets and operations as well as the positive effect of Encana’s focus on developing its U.S. liquids-rich assets. This means that it is very attractively valued, and once the Newfield acquisition is complete, thereby eliminating the execution risk associated with the deal, Encana’s stock should soar once it starts reporting considerable improvements in its operations. The increase in earnings and free cash flow will also underpin the planned 25% dividend hike and increased budget for Encana’s share buyback, which will act as tailwinds for its market value.
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Fool contributor Matt Smith has no position in any of the stocks mentioned.