Opportunity emerges

We issued a traffic light recommendation on Encana (US:ECA) three weeks ago in FAT121. The company is among the largest holders of gas and oil resource land onshore North America, and is a technical and cost leader in the in-situ recovery of oil sands bitumen. In our opinion Encana offers robust leverage to rising energy prices. Following strong full year results and given recent stability in the oil price, an appropriate buying opportunity has now arisen in our view.

Full year results released in mid-February were robust. Operating earnings increased an impressive 73 percent to US$3.24 billion due to higher gas volumes and strong prices.

We are particularly encouraged by Encana's ability to restore resources consumed. In 2005 the company replaced 271 percent of full year production. Total proven reserves increased by 18 percent to 18.5 trillion cubic feet of gas equivalent.

EnCana's portfolio of long-life resource plays include 10 key properties in Canada and the United States, eight producing natural gas and two focused on oil. These unconventional resource assets now represent 55 percent of production.

Last month production from the large Foster Creek project averaged about 40,000 barrels per day (bopd), while total in-situ oil sands volumes exceeded 50,000 bopd. The production capacity of Foster Creek is expected to increase to 60,000 bopd by year-end.

Inflationary pressures have however prompted EnCana to rein back drilling plans in areas where costs have increased the most. As a result the 2006 upstream capital investment forecast has been cut by US$500 million. The effect on this year's gas sales forecast has been a reduction of around 75 million cubic feet per day (cfd). Nevertheless in our opinion such a disciplined approach to capital management is essential if shareholder value is to be properly maximised.

Full year gas production next year is still expected to be between 3.42 billion to 3.56 billion cfd. Declining production in conventional oil properties and higher royalty rates should be mitigated by growth from expanding oil sands. Full year operating costs are forecast at 65 to 69 cents per thousand cubic feet of gas equivalent, which leaves Encana amongst the lowest cost operators in the industry.

Encana's Canadian oil sands assets have tremendous potential. These properties contain an estimated 40 billion barrels of original oil in place, with recoverable resources of between 5 and 10 billion barrels. Management are targeting a twelve-fold production increase from current levels to around 500,000 bopd within the next 10 years. Encana believes these oil-sands projects could translate into a growth rate of 15 to 20 percent in North American oil and natural gas liquids sales between 2006 and 2009.

From a balance sheet perspective Encana is in sound shape. Net debt to market capitalisation and EBITDA (earnings before interest, tax, depreciation, and amortisation) stood at 34 percent and 1.1 times respectively at the end of the year. Further improvements are expected, along with share buybacks, following a series of non-core asset sales which will generate between US$3 and US$3.4 billion.

We believe the huge growth potential offered by the development of oil sands will position Encana strongly to take advantage of an ongoing bull market in energy. We are also encouraged by signs of stability in oil and gas prices following the recent correction. Long-term supply and demand fundamentals are supportive of higher prices in our opinion, making exploitation of these resources economical. Geo-political tensions particularly in the Middle East also look set to underpin energy prices for some time.

From a fundamental perspective Encana offers sound value with a price earnings multiple around 11 times. Accordingly, we recommend Encana as a buy to Members around US$42.