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North American players seek Asian lifeline

Encana strikes unconventional gas deal with Japan’s Mitsubishi as market fundamentals spook shale-gas bulls

Despite battered North American natural gas markets, Asian buyers continue to prop up struggling producers with multi-billion dollar production ventures. Japan’s Mitsubishi is the latest to reaffirm its shale-gas aspirations with its $2.8 billion entry into Encana’s Cutbank Ridge play in northeast British Columbia.

The deal sees Mitsubishi gain 40% of  409,000 undeveloped acres at a time when Encana, Shell and others are pressing ahead with liquefied natural gas (LNG) export plans off Canada’s west coast. For Encana, it gains a much-needed cash injection at a time when battered North American gas markets have taken a toll on its bottom line.

“Mitsubishi looks forward to tapping new natural-gas supplies for the long-term development and eventual delivery to world markets," said Jun Yanai, Mitsubishi's executive vice-president who oversees the conglomerate’s energy division.

North American producers struggle

The Mitsubishi deal overshadowed Encana’s weak financial results, which took a hit from low North American natural gas prices. Encana, which reports in US dollars, recorded a net fourth-quarter loss of about $246 million. Excluding special items, it eked out an operating profit of $46 million or just six cents a share.

Encana’s share price has been punished since it cancelled a $5.5 billion deal with PetroChina last summer. While the PetroChina deal would have seen the Chinese firm operate production, the Mitsubishi deal is for the undeveloped land only, reflecting a more cautious, but optimistic, outlook for longer-term supply. It also reflects Encana’s need to find outside sources of capital to help it fund extensive drilling programmes.

Chief executive Randy Eresman said the company hopes to sell another $500 million worth of assets this year and further reduce its holdings at Cutbank Ridge by an additional 10%.

Even as it was moving ahead with the Mitsubishi deal, Encana said it would slash spending to pay down debt, and shut in some 600 million cubic feet a day of uneconomic production. But those austerity measures weren’t enough to win the support of the financial community which responded with indifference to the company’s cost-cutting moves.

On the first full day of trading on 21 February, Encana’s shares dipped 10 cents on the New York Stock Exchange, to $20, despite a broader market rally that pushed the Dow Jones to its highest levels since 2008.

Analysts said the Mitsubishi transaction would add much-needed balance sheet strength, but Encana’s shares are trading near all-time lows since it was formed from the merger of PanCanadian Petroleum and Alberta Energy in 2001.

In 2010 Encana spun off its oil-sands assets into Cenovus Energy to become a pure-play gas producer. With the benefit of hindsight, the split proved to be ill-timed as North American gas prices tanked. While Encana has struggled, Cenovus shares are near an all-time high of $39.43 in New York. Many fear that Encana is ripe for takeover by foreign interests.

Beating a retreat

But Encana isn’t the only large unconventional gas producer to shift gears and and make a strategic retreat. Oklahoma’s Chesapeake Energy has also been prompted to sell billions of assets and rethink its growth strategy, even as it reported stronger fourth-quarter results.

The US’s second-largest gas producer said it would sell up to $12 billion of production pipelines and undeveloped land, more than 25% of its $41 billion enterprise value, to help bridge a growing budget shortfall estimated to be about $3 billion a year. Chesapeake has also vowed to pay down another $2 billion of debt. The company has put almost its entire holding in the Permian basin – almost 1.5 million acres – up for sale. Chesapeake said a number of firms have expressed interest in the assets, adding possible buyers include Occidental and Apache Corporation.

In a statement, the company said the sales would more than offset any cash flow shortfall in the face of a bearish outlook for Nymex futures, which fell about 3% to $2.60 per million British thermal units (Btu) on 21 February. That is well below the $6/million Btu industry insiders say is sustainable, and some of the lowest North American prices since 1999.

Undeterred, companies like Chesapeake have continued to increase production even as prices have fallen. As recently as November last year, Chesapeake chief executive Aubrey McClendon vowed to keep drilling even if it meant outspending revenues. Now the company says it plans to “fully fund” future capital projects. Despite relatively positive financials, concerns have been growing that Chesapeake is stretched thin as it struggles to maintain market share in money-losing basins like the Haynesville and Marcellus.

Although fourth-quarter profits rose to $429 million from $189 million in the fourth quarter of 2010, full-year profits dipped to $1.57 billion from $1.66 billion the prior year despite a 15% jump in production, to 3.6 billion cubic feet a day (cf/d).

That was achieved only with a $315 million hedging gain that added $1.23 or 25% to Chesapeake’s realised gas price of $5.08/million Btu. It’s a troubling downward trend. Excluding hedges, Chesapeake’s gas sold for $3.87/million Btu, down from $5.22/million Btu in the fourth quarter of 2010.

But the party could be short lived. Chesapeake has no open gas hedges for 2012 or 2013, which means it is completely exposed to spot markets – and spot prices have plunged 30% in the first two months of the year. In addition, the company has vowed to shut in 1 billion cf/d of output and delay new production additions that will slow, or even reduce, growth in future quarters.

Shake-up looming

The about-face is a growing reminder of a looming structural shake-up in the North American unconventionals sector. It’s becoming harder for companies like Encana and Chesapeake to take dominant positions in all of North America’s emerging basins. As big as they are, the resource is bigger and both firms are coming to realise they don’t have enough money to keep a finger in every emerging pie.

Now they’re being forced to prioritise operations and increase liquids production. Plays are competing against each other for capital even as Asian investors are courted with lavish production ventures. But even Chinese and Japanese dollars won’t be enough to fill the gaping hole between future costs and projected revenues, especially if natural gas prices continue to fall.

After three years of defying fundamentals, it appears North America’s biggest gas bulls are finally turning into bears.

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