Encana Corporation (OVV 0.87%) has embarked on a new strategy to become a leaner, meaner energy producer by aggressively cutting costs and focusing on liquids-rich opportunities in North America. Let's take a closer look at some of the key aspects of its new strategy and whether or not it will pay off.
Encana's aggressive focus on costs
This year, the Canadian natural gas giant expects to spend just $2.4-$2.5 billion, down from $3.5 billion in 2012 and $4.6 billion in 2011. To help achieve this drastic capex reduction target, the company has already pledged to reduce its workforce by a fifth, cut its quarterly dividend from $0.20 per share to $0.07 per share, and spin off its Canadian Clearwater assets into a new public company.
It is also cutting costs by using a lot more natural gas in its operations. Roughly half of the company's drilling rigs are now burning natural gas, resulting in annual fuel cost savings of $200,000 to $1.5 million, according to CEO Doug Suttles. The company is also using gas to power almost a third of its fleet of pickup trucks.
Encana's renewed cost-cutting focus comes amid continuing challenges resulting from its high degree of leverage to natural gas. Roughly 90% of the company's production is dry gas, with the remaining 10% consisting of oil and natural gas liquids. Though gas prices have surged in recent months, they're still not high enough for the company to generate enough cash to fully pursue its development opportunities.
A new strategic direction
That's why it has decided to allocate roughly three-quarters of its 2014 capital budget toward five liquids-rich plays, including Canada's Montney and Duvernay shales, Colorado's DJ Basin, New Mexico's San Juan Basin, and the Tuscaloosa Marine shale in Louisiana and Mississippi. In doing so, it joins a growing chorus of traditionally gas-focused producers who have sought to diversify their commodity mix in recent years.
Chesapeake Energy (CHKA.Q), for instance, is devoting the largest portion of its drastically reduced capital budget toward liquids-rich opportunities in the Eagle Ford and the Greater Anadarko Basin. Though it still maintains significant operations in Pennsylvania's gas-rich Marcellus shale, the company will continue to focus on growing oil production at double-digit rates as it seeks to reduce leverage and shore up its balance sheet.
Similarly, Devon Energy (DVN 0.78%) has completely stopped dry gas drilling and is focusing the largest portion of its capital on oil-rich plays such as the Permian Basin and the Mississippian-Woodford trend. With its recent entry into the Eagle Ford shale, Devon will continue to focus on oil plays for the foreseeable future, or at least until natural gas prices recover significantly.
Even Ultra Petroleum (UPL), a pure-play natural gas producer like Encana, is seeking to diversify away from natural gas. Last year, the company purchased oil-rich assets in Utah's Uinta Basin for $650 million, which are expected to generate solid rates of return in excess of 100% and provide a strong boost to the company's cash flow.
Like these companies, Encana hopes its focus on developing liquids-rich plays will provide a significant boost to oil and natural gas liquids production. Over the longer term, the company's goal is to derive three-quarters of its cash flow from liquids by 2017, and grow cash flow per share by more than 10% annually through 2017.
Will it pay off?
Though Encana has seen strong initial success from its transition toward liquids-led growth, as evidenced by 92% year-over-year growth in third-quarter liquids volumes despite the lower level of capex spending last year, the company's true test will be in its ability to successfully exploit its five liquids-rich assets.
Though these plays promise relatively strong economics, operating costs in the Montney and Duvernay shales could turn out to be higher than anticipated based on recent results from other operators, lowering Encana's returns. Investors should keep a close eye on the company's success in accelerating liquids growth, especially in the Montney and DJ Basin, as well as the results of appraisal programs in the Duverney and Tuscaloosa Marine shales.
