Canadian shale driller Encana (NYSE: ECA) has engineered a remarkable turnaround over the past couple of years. The company sold low-margin, growth-constrained gas assets and used that cash to buy higher margin, growth-focused oil assets as well as repair its balance sheet. The results have been phenomenal and have ignited the stock, which has more than doubled from last year's bottom.
For investors who took a flier on Encana in the last two years, it can be tempting to cash in on this run. However, that would be the worst mistake they could make, in my opinion, since the company is just getting started on its five-year growth plan. That plan has the potential to fuel even more gains, especially given the increasing likelihood that Encana could outperform its goals.
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A trip down memory lane
As a result of completing its financial and portfolio makeover, Encana unveiled a new five-year growth plan last October. Underpinning that strategy was four world-class assets that held nearly 10,000 premium drilling locations that could earn the company a 35% direct after-tax rate of return at $50 oil. While that hurdle rate wasn't quite as high as the 30% return at $40 oil that EOG Resources (NYSE: EOG) set for its premium drilling inventory, it was still enough to position Encana to deliver healthy growth in a low oil price environment. In the company's estimation, it could drill enough of those wells over a five-year period to increase the output from its core assets by 60% while growing cash flow from operations by 300% as long as oil averaged $55 per barrel. The company believed that its rapidly growing cash flow stream would provide the fuel needed to drive its stock higher.
As ambitious as that plan was, Encana has managed to stay well ahead of pace over the past year. Last quarter, for example, the company reported robust production results, with liquids output jumping 14%, which fueled a stunning 25% increase in its corporate margin despite lower oil prices. Fueling those blowout results is that production from Encana's newest wells came in well above expectations. In the Permian Basin, for example, wells were 20% above forecast thanks in part to the company's cube innovation, which is a large multi-well pad that uses an advanced well completion design, and more efficiently uses equipment and infrastructure. Because of advancements like that, Encana now only needs oil to average $50 a barrel instead of $55 to achieve the goals of its five-year growth plan. Furthermore, the company noted that it now has 11,000 premium return locations, even though it has already drilled 230 wells from its initial inventory, which means it could continue growing at a rapid pace in future years or even accelerate its growth rate if crude rebounds sharply.
Still just getting started
Encana's ability to lower the oil breakeven level needed to fuel its long-term growth plan is a game-changer for the company. It's now in an elite class of shale drillers that can thrive at $50 oil. However, the rapid pace of advancements in the sector over the past year suggests that Encana might still have more upside to its plan. That has certainly been the case at EOG, which initially thought it could increase oil output by a 10% compound annual growth rate through 2020 at $50 oil but now anticipates delivering 15% compound annual growth at the oil price.
One of the biggest drivers of these productivity gains has been the continued innovation of well designs, which includes drilling longer horizontal laterals and using more sand to complete wells. This combination is enabling drillers to complete a gusher of record-breaking wells this year. EOG, for example, unveiled monster well results in the Delaware Basin when its four-well Whirling Wind pad delivered an average 30-day initial rate of 5,060 barrels of oil equivalent per day (BOE/d) per well. CEO Bill Thomas noted that the well "shattered industry records in the Permian Basin," which he attributed to EOG's "advanced technology and proprietary techniques." Meanwhile, Devon Energy (NYSE: DVN) reported a record-smashing well in the Stack play of Oklahoma this year, with it delivering a peak 24-hour rate of 6,000 BOE/d. Devon Energy noted that a combination of drilling a 10,000-foot lateral as well as using a "new proprietary completion design" contributed to this prolific well.
As these innovations become standard practice, it should enable those companies on the cutting edge to continue delivering expectation-beating results. Given that Encana is one of the companies on the forefront of innovation, it's in an excellent position to exceed its forecast, which could create more value for investors over the coming years.
It's way too early to cash in
While Encana's stock has bounced sharply over the past year, it's just getting started on its five-year plan. That strategy has the potential to dramatically expand the company's margins and cash flow, which should ultimately increase shareholder value. Furthermore, given its recent outperformance and the rapid pace of industry innovation, it's increasingly possible that Encana could vastly outperform expectations. That's why investors shouldn't make the mistake of cashing in after this run-up. They could be leaving money on the table.
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