Canada Oil And Gas: All's Well. Or Is it?

Despite a few quiet tears, Gwyn Morgan is surprisingly calm about his resignation as president and CEO of EnCana Corp. In a brief display of emotion during the Calgary meeting on Oct. 25 when he announced his decision to step down at year's end, Morgan paused as his eyes welled. “I've been very serene about all this, but when I started talking about my life's work, it sort of hit home,” he told Canadian Business shortly after the announcement. “I guess what I feel is almost a sense of awe as to what our company has grown into, starting from nothing. I could never have imagined leading a company of this size or of this significance.”

Significant is an understatement. EnCana is one of Canada's biggest corporations, with a market capitalization of more than $49 billion. It's also North America's leading natural gas producer and largest independent oil-and-gas company. But with all that's happened in the past few weeks, it's no wonder some people are anxious about EnCana's future.

First, rumours of a potential takeover bid by Royal Dutch Shell PLC triggered a stock buying spree. But when EnCana quashed those rumours on Oct. 20, its share price (TSX: ECA) fell $4.80, to $56.85. Five days later, Morgan announced his intention to step down–less than four years since orchestrating the merger between PanCanadian Energy Corp. and Alberta Energy Co. Ltd. (AEC) that formed EnCana. Though he will stay on as executive vice-chairman in 2006, working mainly as an adviser to his successor, Randy Eresman, the current chief operating officer, the timing of Morgan's announcement rekindled speculation that a takeover really is in the works. Finally, a day later, the firm released its third-quarter results, in which it lowered its production guidance for 2005 and 2006, showed a US$604-million unrealized hedging loss, hiked its capital spending budget and revealed that earnings are down.

But according to many EnCana watchers, there's no reason for investors to be confused. Morgan certainly laid out his reasons for retiring: he was going to be turning 60 in early November, had been working in the industry for 30 years, and wanted to focus on family, travel and other business interests. The transition from Morgan to Eresman seems flawless. Eresman has been with the company since 1980, first at AEC, then at post-merger EnCana. He is known as the architect of EnCana's resource-play strategy and is well respected within the company. “From what I can tell,” says Bob Schulz, professor of strategic management at the University of Calgary's Haskayne School of Business, “Gwyn Morgan has been mentoring Randy Eresman for probably 20 years. It was widely expected inside EnCana that Eresman would be the heir apparent to Morgan whenever the time came.” Schulz says Eresman has been in the background at important meetings for years. Now the two men will simply reverse roles, with Eresman at the helm and Morgan providing advice and support. “That's a perfect mentoring role,” says Schulz. “That actually shows the way transitions at the corporate leadership level should be handled.”

Besides having a smooth succession plan, the company's strategy of focusing on North American resource plays that are unconventional is unwavering. Having recently completed major international asset sales, EnCana is prepared to focus on the natural gas at its drill tips in western Canada and the United States. Morgan says the company is on a straight course. “Certainly, Randy and his team will always have new ideas, but the idea of building around our North American resource-play business is firmly in place,” he says. “That's what we'll be doing.” Indeed, EnCana plans to drill 5,000 wells by the end of the year; a challenge, considering it drilled 2,455 in the first three quarters, according to its Q3 release.

With the new drilling activity in store and a coming winter that experts say will put more upward pressure on already high natural gas prices, people are wondering, why step down now? Even Morgan acknowledges the board was surprised when he told them of his plans in August. Schulz has a theory: “What I saw is that Gwyn could stay around for five years, implement the gas strategy, make a lot of money for EnCana, look good. But then Randy would be in the background. So I saw this as Gwyn Morgan being a good team player to let Randy Eresman shine.”

Or not. The idea of a selfless team-like hand-off has Ben Dell, senior research analyst with Sanford C. Bernstein & Co. LLC, laughing over the phone from New York. “You're welcome to write what you think,” he says. “If you can point out to me where in the numbers or the results there's evidence of that coming through, I'll happily retract everything I've said.” Dell's outlook is sobering: he has the one and only Underperform rating out of 26 analysts covering EnCana (more than half recommend Buy). “Gwyn bowed out the day before they missed earnings consensus numbers by 23%,” says Dell. “They've lowered their production guidance, they're raising [their capital expenditure] and their costs are going up. I do feel, to some extent, Gwyn's delivered [Randy] something of a poisoned chalice.”

It's not just EnCana's poor third-quarter results that make Dell skeptical. At the end of July, he released a report comparing Burlington Resources Inc. (NYSE: BR) a company with a similar North American gas portfolio, and EnCana to beauty and the beast. Burlington managed to beat consensus expectations by 13%, while EnCana missed by 5% in the second quarter. “Burlington is not only matching EnCana's production growth on a per share basis,” he wrote, “but the company is doing it while spending less, while suffering lower cost inflation, and while delivering superior returns.” Dell recommended going long Burlington and short EnCana. Now that third-quarter results are in and Burlington hit its numbers again, Dell says this is beauty and the beast, Part 2. “The problem you have with [EnCana] stock,” he says, “is a lot of the belief in why people want to own it is the future promise of something great happening. And every time you look at the earnings numbers and the results, they don't support that thesis. The numbers don't add up. They don't deliver the cash flow generation or the earnings that that story would suggest.”

What about the takeover rumour? “I just think it's rubbish,” says Dell, though he acknowledges if anyone could do it, it's Shell. He says that Encana's recent stock slide makes it more affordable to acquire, but it's still not a good deal. “While the stock's become cheaper, it's also become more unattractive to buy because questions are emerging about the actual story,” says Dell. Besides, he points out, if Shell were to acquire EnCana, it would dilute every single metric, such as earnings, cash flow and returns, potentially endangering Shell's credit risk. Meanwhile, Shell has reiterated that it's not looking at acquisitions above US$10 billion, and EnCana would have to fall a long way to meet that criterion.

In Dell's latest report on the Canadian company, he writes: “While Encana's decision to focus on U.S. natural gas appears to be an astute strategic move, we believe the challenges to delivering real EPS [earnings per share] and CFPS [cash flow per share] growth from here are significant.” Dell says its strategy to grow at any cost is catching up with EnCana, more bad news is on the way, and expectations surrounding the company need to be lowered. With EnCana stock currently trading at a premium to its peers, he says it has room to fall about 20%. The incoming CEO may be in for a rough ride. “It couldn't make life much more uncomfortable [for Eresman],” says Dell.

Over the phone from Calgary, however, there is no whiff of a problem coming from Morgan. “Randy Eresman is 47,” he says, “and I'll be looking forward to hearing from him when he's 60 as CEO of the company.” All depends on the chalice.