Encana's (NYSE:OVV) growth engine stalled out in the third quarter due to a combination of factors that included an asset sale, Hurricane Harvey, and some infrastructure issues. However, the company noted that it ramped back up shortly after the quarter ended, which set it up to finish 2017 with production levels well above where it initially anticipated. That's one of three things investors can expect to see when the Canadian shale driller announces its fourth-quarter results on Thursday morning.
Expect a gusher of production
Despite some headwinds in the third quarter, Encana was "firmly on track to meet or beat its 2017 targets," according to CEO Doug Suttles. One of the drivers of this expectation at the time was that the midstream constraints that held it back earlier in the year would go away because its infrastructure partner Pembina Pipeline (NYSE:PBA) was finishing up three new gas processing plants in the Montney Shale region of Canada ahead of schedule. Furthermore, Pembina Pipeline also finished a pipeline that connected those plants to a major regional gas transportation system.
The belief that output would rocket in the fourth quarter proved to be correct since Encana reported last month that production from its core assets was 31% higher at the end of the year than it was at the beginning of 2017. That rate was above the high end of its guidance range of 25% to 30% year-over-year growth, and even further above its initial outlook that output would end the year 20% higher. Fueling Encana's fine finish was the Montney region, where liquids production more than doubled year over year thanks to the early start-up of the Pembina Pipeline plants.
Expect more of the same in 2018
Encana expects this momentum to continue in 2018, with it guiding in last month's production update that output would rise another 25% to 35% by the end of this year. Two factors will drive this growth. First, the company expects to continue ramping output in the Permian Basin, where it ended last year well ahead of its target. Meanwhile, production from the Montney region will also continue to rapidly increase, with the company expecting to fill the processing capacity of all three newly constructed Pembina plants, which will drive the need for two more hubs in the second half of the year.
Encana expects to fuel this growth within operating cash flow, with the company believing it can generate about $2 billion in cash at $50 oil. That would put its spending level close to the $1.8 billion it invested last year.
Expect the company to be conservative with its free cash flow
One thing that's worth noting about Encana's plan is that the company only needs oil around $50 a barrel to finance it going forward. In fact, at that oil price, the company can fund the growth necessary to expand its cash flow at a 25% compound annual rate through 2020. Furthermore, its plan would generate about $1.5 billion in free cash over that time frame.
At $50 oil, Encana's strategy wouldn't start producing excess cash until next year. However, with crude in the $60s, Encana could have more money than it needs this year. That leaves it with several options for that cash. It could pay down debt, return more capital to shareholders either through a higher dividend or share buyback program, or accelerate its growth rate.
Most rivals are choosing to allocate their excess on the first two options. Anadarko Petroleum (NYSE:APC) and Pioneer Natural Resources (NYSE:PXD), for example, both announced plans to spread their wealth across a variety of options. In Anadarko Petroleum's case, it added $500 million to its share repurchase authorization, planned to repay $1 billion of maturing debt, and increased its dividend fivefold, which put the payout nearly back up to its peak before oil prices crashed. Meanwhile, Pioneer Natural Resources delivered a fourfold dividend increase, planned to repurchase some shares, and said would also pay off an upcoming $450 million debt maturity with cash.
While it's possible that Encana could also spread the wealth around, I'd expect the company to focus on debt repayment first before it starts ramping up cash returns to investors. The company plans to get its leverage ratio down to 1.5 by 2019 after ending last year at about 2.0. It could hit that goal quicker by allocating any excess cash toward paying down debt.
Expect another reminder that Encana is in an elite class
Encana has already provided a glimpse of what to expect in the fourth quarter by unveiling its production results last month. That report increases the likelihood that the company delivered a fine quarter and is on pace for a strong 2018. About the only question that remains unanswered is what Encana will do with future free cash flow, which it might hint at this quarter. It's that free cash flow, which Encana can produce at much lower oil prices, that makes it a top oil stock to consider holding as the oil market recovery takes hold.