Encana (OVV -0.43%) has shifted its focus in recent years. Gone are the days of increasing production no matter the cost. Replacing that mind-set is an aim to grow cash flow and shareholder returns.
That shift is leading the company to take innovative approaches to not only drilling new wells but in building the infrastructure needed to support future production. That creativity was on full display with this latest deal.
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Drilling down
Encana announced this week that it reached an innovative agreement with Keyera Corp. (KEY 0.09%), a midstream company in Canada. Under the terms of the deal, Keyera would acquire and fund the remaining development of Encana's Pipestone Liquids Hub as well as the planned Pipestone Processing Facility. Encana will receive 39 million Canadian dollars ($30 million) at closing, while Keyera will spend the estimated CA$105 million ($81 million) needed to finish construction on these projects. Once they start up, Keyera will provide Encana with processing services in the Montney shale of Canada under a competitive fee-for-service agreement, which will increase its flexibility while reducing its financial obligations.
That agreement is worth noting because it's a departure from the traditional take-or-pay contract structure that producers typically sign for midstream services. Those agreements, which require that producers pay for a specified level of volumes on pipelines and processing plants, provide midstream companies with predictable cash flow. However, those fees have proven burdensome to drillers when commodity prices are in decline.
Chesapeake Energy (CHKA.Q) was one of the many drillers hamstrung by midstream contracts during the recent industry downturn. The company had secured several long-term service agreements with midstream companies to support future growth during the boom years. However, when oil and gas prices dropped, Chesapeake Energy couldn't increase its volumes to meet those minimum volume commitments. That negatively impacted margins, further hindering its ability to grow. Because of that, Chesapeake Energy restructured many of its midstream agreements in 2016 to gain some additional breathing room.
Image source: Getty Images.
Focused on growing what matters most
Encana's transaction with Keyera shares many of the similarities to the company's groundbreaking midstream agreement in 2014 with Veresen, which is now part of Pembina Pipeline (PBA 0.44%). Under that deal, Encana sold some of its natural gas gathering and compression assets to a joint venture between Veresen and a private equity fund. That entity pledged to invest upwards of CA$5 billion ($3.9 billion) in developing midstream assets for Encana. These included the Sunrise, Tower, and Saturn gas processing plants, which Pembina completed last year, as well as the Towerbirch pipeline that linked those plants to a large midstream system in the region.
Not only did that agreement offload the capital cost to construct those and future assets, but the deal structure reduced "Encana's commitments compared to the typical "take-or-pay" fee structure embedded in traditional midstream arrangements," according to the company. As a result, it increased "Encana's financial flexibility and mitigate[ed] its exposure to long-term unutilized demand charges." This most recent deal with Keyera features those same benefits.
These creative transactions allow Encana to focus on drilling wells that maximize its returns, not fulfill an obligation. That approach has it on pace to increase cash flow at a 25% compound annual rate through 2022, and that's assuming $50 oil. In fact, the company's current plan would see it generate more than $1.5 billion in excess cash over that timeframe since it doesn't need to plow every dollar into increasing production.
Focused on growing value
Encana has creatively pursued midstream agreements that keep it in control over its destiny. Consequently, it can drill wells that create value for investors as opposed to those needed to meet a commitment. That value-focused growth has the company on pace to generate significant cash flow in the coming years, which should boost shareholder value, especially as it uses a growing portion of that excess to buy back its beaten-down stock, including plans to repurchase $400 million this year alone.
