Description

SUMMARY: EnCana Corp. (“ECA”) is the third largest natural gas producer in North America yet also one of the fastest growing. The U.S. natural gas market has proved increasingly volatile and inflexible, with most every North American producer experiencing declining organic production. With 10% year over year growth in production, the largest North American reserves and undeveloped land, ECA is primed for growth. In addition to its resources, ECA is trading at 4.3X LTM cash flow, boasts a healthy balance sheet and could be a key player in likely consolidation amongst independent oil and gas producers.

All figures, including stock price and market cap, in Canadian $ unless otherwise noted. Current exchange rate approximately .74 US$:C$.

BUSINESS:

ECA was formed in April 2002 in a merger of Alberta Energy Company and PanCanadian Energy making it the largest independent oil and gas company in North America. ECA inherited massive reserves, primarily in Western Canada, with approximately 60% of its reserves in natural gas, 40% oil. In addition to its land base in Western Canada, Encana has land in the U.S. Rockies, Eastern Canada and development projects in the North Sea and the Gulf of Mexico. Additional development in Ecuador has exceeded expectations. 100% of reserves are verified by independent engineering firms under the supervision of an independent board committee.

The company had 10% growth in 2002 production from continuing operations and expects 10% growth in 2003 and 2004. ECA expects to have 2003 produced sales of between 3 and 3.1 billion cubic feet of natural gas per day and 240,000 and 280,000 barrels of oil and natural gas liquids per day. ECA’s operating costs of C$4.03 per barrel of oil equivalent and proved reserve replacement cost of C$9.60/barrel of oil equivalent (before royalties) are competitive and demonstrate the company’s technology and cost structure are in place to make profitable use of its ample reserves and future production.

GROWTH FROM RESERVE BASE:

ECA predicts 10% growth in production and reserves annually for 2004, 2005 and 2006 with BOE/share (before royalties) growing from approximately .5 in 2001 to .8 in 2006. ECA should be able to meet these targets as its production estimate is based on proved reserves only and ECA, with its vast probable reserves, huge tracks of undeveloped land (17million acres) and offshore areas (77million acres) and large-scale technology driven developments should be able to find new reserves at that rate. ECA estimates it has 9 trillion cubic feet of gas and 650 million barrels of oil reserves not currently classified as proved or probable on its North American lands. This reserve base is the key to ECA’s growth prospects and ECA is implementing a C$6.7B capital expenditure plan for 2003.

ECA has proved reserves (as of 12/31/02) of 9 trillion cubic feet of natural gas, 980 million barrels of oil/ngl. ECA’s probable reserves are 3.5 trillion cubic feet of natural gas and 750 million barrels of oil/ngl. ECA also boasts a lower and steadier decline rate than the industry average.

The discounted future net cash flows from proved natural gas and oil/ngl reserves is, based on a 10% discount rate, C$19,986m after taxes. This gives ECA a NAV/share (diluted) based on proved reserves alone of C$41/share. With probable natural gas and oil reserves representing potential 38.5% and 77% additions to BOE reserves, respectively, and unbooked reserves another 100% and 67%, respectively, even at appropriate discounts for time value, risk and cost of development, the NAV/share for this company should be significantly greater than its market price.

ECA has extensive natural gas storage facilities (145 billion cf of storage with 2.7 billion cf/day withdrawal rate) of its own which will allow it to capitalize on peaks in natural gas prices. ECA has also hedged commodity prices and exchange rates to reduce volatility, which has paid off in the short-run.

VALUATION:

While ECA has reserves, production trends and financial strength far above average, it sells at a discount multiple:
- P/E 12.18 (v. 31.71 for the AMEX Natural Gas Index - XNG),
- 1.54 price/book and (v. 1.618 for XNG)
- 4.3X LTM cash flow (v. 5.2 for XNG)
- ECA currently has a return on common equity of 13.57%
- 52wk H/L: C$53.55/40.60

EARNINGS/CASH FLOW:

ECA had slightly disappointing Q2 results C$.79/EPS (excluding .41 of exchange rate gain and 1.02 of one-time tax breaks - 2.23 all-in) v. C$1.02 consensus – due to low natural gas production in Canada, however, ECA’s cash flow/share of C$3.05 beat consensus of C$3.00. Six month cash flow/share is C$6.75/share (diluted). ECA’s has a trailing 12 months EPS of C$3.94.

PRICING OUTLOOK:

The current pricing outlook for natural gas and oil is cloudy given the many market uncertainties with Iraqi, Russian and OPEC supply. With no new major oil & gas discoveries in many years, demand for these resources is increasing. China, for one, expects 4% annual growth in demand through 2005. We would expect this rate to accelerate as China’s current per capita rate of oil consumption approximately 3.8 barrels/1000 people is a mere 5.4% of current U.S. per capita consumption.

Changes in oil and/or gas prices would have a significant effect on ECA’s cash flow and earnings. ECA estimates that a US$0.25/MMbtu increase in natural gas prices would cause a C$135m increase in earnings (C$0.28/share) and a C$200m increase in cash flow (C$0.42/share). A US$5 per bbl increase in oil prices would increase earnings by C$200m (C$0.42/share) and cash flow by C$300m (C$0.63/share).

BALANCE SHEET:

ECA has improved its balance sheet considerably in large part by selling its interest in the Syncrude (oil sands) joint venture and certain pipeline assets, reducing long-term debt from C$7,395m at the end of 2002 to C$6,122m June 30th. Long-term debt to capitalization of 27.3% and 13.25X interest coverage leave ECA with a solid financial position for growth.

RISKS:
- Encana’s cash flow and profitability are tied to the North American oil and natural gas markets.
- While proved reserves support the current stock price, future growth depends on proving out probable and unbooked reserves.

Catalyst

Large independent oil and gas company with solid cost structure and underlevered balance sheet and unparalleled reserves and reserve base. Trading at only 4.30 price/cash flow. Ideal target or acquirer in coming consolidation of North American independents. Reserve base gives EnCana impressive growth prospects in North American natural gas and oil markets.