The US natural gas producer has performed well since our buy recommendation at US$43.50 in March, delivering an attractive return in excess of 30%. The stock is also up a similar amount since our original recommendation, which is a reasonable result given the turmoil witnesed in financial markets over the past 2 years, and the substantial retracement in energy prices from their 2008 highs. This week, we explain why we think the time has come to take some profits off the table.

As we have discussed in previous reports, although natural gas prices collapsed from their 2008 peak, Encana’s hedging strategy served to buffer the company from the worst of the declines. Highlighting this is the company’s second quarter performance.



Encana’s second quarter operating earnings fell 38% from the same period last year, to US$917 million. Nevertheless, the company’s commodity price hedging delivered a very welcome US$900 million after tax gain. The positive effect of the hedge book is set to continue through the current period. Management previously hedged some 66% of the company’s production at US$9.13 per Mcf (thousand cubic feet) through to October 2009.

Looking further ahead though, the hedge buffer is considerably less robust. Only 45% of Encana’s 2010 production guidance is hedged. Moreover, the current hedge book locks in a significantly lower price at US$6.09 per Mcf. Expectations are for natural gas prices to remain relatively weak through 2010, due in large part to a significant increase in domestic supply.

From a charting perspective, there has been an encouraging improvement in the outlook for EnCana over recent months. As evident on the daily chart, following a lengthy period of consolidation between support at US$34 and resistance at US$55, prices have recently broken to the upside. With the break higher yet to be sustained, we cannot rule out a temporary dip back within the range in the near-term. Nevertheless, we believe that downside risks are limited to the rising trend line in the US$50 region.

Meanwhile, management has re-established previous plans to split the company into separate oil sands and natural gas businesses. Management expects the split to drive a re-rating for each business, because each will provide “pure-play” exposures for investors.

The oil sands business, Cenovus Energy Inc, will retain Encana's Northern Albertan oil sands operations, the refining assets, and its Western Canadian conventional natural gas operations. The company's shale gas and other unconventional natural gas projects will remain under the control of Encana.

Management’s decision to split the business is in our view a positive move. Nevertheless, we believe the stock’s recent rally has already priced in much of the “unlockable” value. Given the potential for a broader market pullback, or period of consolidation, we think it is unlikely that the split will deliver an immediate gain.

As such, we believe now is an opportune time to lock in some of our profits on Encana and we recommend that Members sell half their holdings around US$57.40. This is also opportune given recent weakness in sterling versus the dollar.

Fat Prophets maintain a holding in Encana for longer term out-performance.