Encana was once a made-in-Canada success story that seemed destined to define the very best of the country’s energy sector. How did it all go so wrong?
A series of badly-timed decisions brought Encana down from the heights of Canada’s energy sector. Is it too late to reverse its fortunes?
CALGARY’S BOW TOWER,
with its sleek criss-crossing design and its curvy glass contours, stands in sharp contrast to the city’s otherwise drab skyline. The building rises up from Centre Street to a height of 236 meters, making it Canada’s tallest building outside of Toronto—and, for now, easily Calgary’s tallest. The top suite of the Bow, which serves as the headquarters for Encana, has an air of extravagance, with executive suites that overlook a sky-lit atrium populated with modern furnishings, a lavish auditorium and a multi-story window that overlooks the city.
THE BOW SERVES AS A
sort of monument to the company’s towering ambitions to be Canada’s most successful international energy company. By the time industry legend Gwyn Morgan retired as CEO of Encana at the end of 2005—one year before it unveiled plans for the opulent Bow building—everything was in place for a continued success story. The independent company’s gas reserves had grown by almost a quarter the year before. Cash flow was up by 57 percent. The company had offloaded 740,000 net acres of North Sea assets to Nexen for $2.1 billion in December 2004, adding to its already enviable war chest. Randy Eresman, Morgan’s long-time right-hand man, was elevated to CEO. There was no reason for the dominant company to go anywhere but up.
Fast forward to today. Encana’s share price reached a low of $4.15 in February 2016, marking an 82 percent drop from five years earlier. The company posted a net loss of US$5.1 billion in 2015, compared to a profit of US$3.4 billion the year before (it was dinged with $4.1 billion worth of impairment charges). It cut 20 percent of its staff over that year, and slashed another 20 percent in the first quarter of 2016. Those reductions were in line with industry-wide cost cuts following the plummet in oil prices that began mid2014, but for Encana the pain had been going on for years. A badly-timed expansion into natural gas leading up to the spinoff of Cenovus Energy in 2009 was causing Encana to buckle under a swelling pile of debt. By 2012 it had posted its worst-ever annual earnings results, which included a US$2.79 billion net loss due to writedowns on some of its natural gas assets.
In 2013, Encana brought in Doug Suttles, the BP vet who headed up the Deepwater Horizon disaster response, to implement a rapid pivot back to liquids. But in an almost tragicomic turn of events, his shift toward liquids exposed the company to the eventual plunge in oil prices, with expensive purchases in the Eagle Ford and Permian occurring almost immediately before the downturn. Despite successes, like the company’s ability to cut its per-well costs in some of its main assets, or the lucrative PrairieSky Royalty IPO in 2014, Encana has not managed to escape its past troubles. All of this raises questions about the company that used to be Canada’s foremost energy firm: What can Encana do to reverse its fortunes—and, more to the point, how did it all go so wrong?
THE HISTORIES OF THE ALBERTA ENERGY
Company (AEC) and PanCanadian Petroleum—the two companies that merged in 2002 to create Encana—are magnificent in scope. Together they span 125 years and involve everyone from Canada’s first Prime Minister, John A. Macdonald, to former Albertan premiers Peter Lougheed and Ralph Klein.
PanCanadian was established in 1971 after a merger between Central-Del Rio Oils and Canadian Pacific Oil and Gas Company, which was then a subsidiary of Canadian Pacific Railway. Lougheed created AEC, which began as a public enterprise, two years later. In 1993, Klein privatized the province’s remaining 36 percent stake in AEC, paving the way for the massive 2002 merger.
Gwyn Morgan, who joined AEC in 1975 as an engineer, became AEC’s CEO in 1994, one year after its privatization. Words commonly used to describe Morgan as leader of the newly formed company included “larger-than-life,” “visionary” and “dynamic.” He has been known to tell stories about his modest upbringing in rural Alberta, where he grew up in a farmhouse before quickly rising through the ranks of Canada’s energy industry. Over his tenure at the company, he morphed into one of the energy sector’s most contentious figures. Depending on whom you ask, Morgan is either one of the industry’s most savvy and discerning business leaders, or the head of a company with sometimes brash business operations and a checkered history.
Despite detractors, there is no doubt that the growth of Encana under Morgan’s leadership was substantial. In 1995, the year after he became CEO, AEC acquired Conwest Exploration Company for $1.1 billion, adding excellent West Peace River Arch assets in Alberta to the company’s already strong properties in Suffield and Ogston. The move boosted AEC’s share value by 22 percent to a market cap of $2.2
billion, making it one of the country’s largest oil and gas companies.
AEC expanded rapidly in the following years, with acquisitions in Wyoming’s Jonah gas fields in 2000 and Colorado’s Piceance basin in 2001 (around the same time, PanCanadian was investing in EOR developments in Weyburn and SAGD developments in Christina Lake). Gas prices were on the rise, and AEC grew its net income sevenfold from the fourth quarter of 1999 to the fourth quarter of 2000, rising from $69.2 million to $306 million.
There was also a coinciding appetite for Canadian oil south of the border. In response to the U.S. quest for energy independence, which intensified following the 9/11 attacks, U.S. companies, flush with cash, started scooping up Canadian mid-sized firms. In 2001, there were 104 mergers and acquisitions in the Canadian oil patch, which totaled $27 billion in value. Well-capitalized U.S. producers made up the majority of buyers. It was the next year that PanCanadian and AEC merged to create the $27 billion behemoth under its new Encana logo.
BUT MORGAN’S TENURE ALSO HAD ITS
darker side, and included several spats with local stakeholders over its operations. First came the sparring with Wiebo Ludwig, the fundamentalist-Christian patriarch who caused millions of dollars’ worth of damages in response to alleged trespassing and sour gas leaks that he claimed Encana was responsible for. In 1998, the RCMP allegedly staged a bombing of an Encana-owned shed near Ludwig’s property, with the permission of the company, in attempt to gather information to feed its investigation. The Crown later admitted the allegations were true. Ludwig was also arrested in 2010 for allegations of five separate pipeline bombings between late 2008 and early 2009, but was released without charges.
In 1999, AEC bought up Pacalta Resources and its operations in Ecuador for $748 million, including $274 million in debt. At the time, Morgan described the opportunity as providing “a solid platform for profitable growth in South America.” The company’s operations there appeared to be in good order, particularly considering Encana’s 36 percent stake in the Oleoductos de Crudos Pesados (or heavy crude oil pipeline), which would eventually transport 450,000 b/d of oil from northern Ecuador to Colombian seaports.
But in the years following the acquisition, oil volumes in the pipeline were flowing well below capacity. The legitimacy of Encana’s acquisition was being questioned by locals, who began to protest the perceived lack of compensation to residents in the Amazon basin, as well as claims that operations were causing environmental disturbance.
Toby Heaps, CEO and co-founder of Corporate Knights, visited Ecuador in 2003 and found the pipeline project “scored very poorly” when the International Code of Ethics for Canadian Business was applied to it. He recalls that Encana didn’t respond well to such findings, attempting to “explain away the controversy” by appealing to the fact the project was a joint venture. In September 2005—a month after protesters sabotaged a pipeline owned by Encana in the Orellana province—the company sold all its Ecuador assets to Andes Petroleum Company, a joint venture between Sinopec and CNPC, for $1.42 billion.
Meanwhile, Morgan was heading numerous other deals, including the sale of its 13.75 percent stake in Syncrude to Canadian Oil Sands in February and June of 2003 ($1 billion in two separate transactions), the $2.7 billion acquisition of Colorado’s Tom Brown in May of 2004, and the offloading of its massive Gulf of Mexico assets to Statoil in May of 2005. Years later, then under the direction of Randy Eresman, Encana suffered another reputational setback in its U.S. operations. In 2012 Reuters uncovered evidence suggesting that some executives at Encana had conspired with executives at Chesapeake Energy, including Chesapeake CEO Aubrey McClendon, to keep prices artificially low in Michigan’s Collingwood Shale region during a rush of land sales in 2010. Both companies were charged with separate antitrust violations in 2014 following a lengthy investigation by a state prosecutor, though both companies denied any wrongdoing. Encana agreed to a US$5 million settlement two months later.
AFTER A TURBULENT YET LARGELY
successful tenure, Morgan stepped down as CEO in 2005. He was replaced by Eresman, who had joined AEC in 1980. Sherri Brillon, the executive vice-president and CFO of Encana, notes that “it was much slower for Randy [Eresman] to emerge as an external kind of voice of the company” compared to Morgan, who was “much more visible.” But the somewhat introverted Eresman nonetheless diverged from Morgan on the operations front, committing the company to a future heavily weighted by natural gas plays. By 2007, the company was producing 3.5 bcf/d. No one—and, it seemed, particularly not Eresman—was prepared for the crash in natural gas prices that came in 2008.
Encana’s net earnings plummeted from $3.59 billion in 2008 to $1.9 billion in 2009 as natural gas prices languished. Such a drop delayed the Cenovus spinoff which had been in the works for two or three years—a rain check which Brillon now says was “without question the right call” (the corporate reorganization received 99 percent shareholder support on November 25, 2009). Cenovus took the company’s heavy oil assets with it, making Encana increasingly vulnerable to the drop.
By that point, Eresman had announced intent to double gas production by 2015, and was pursuing aggressive developments in Wyoming, Colorado’s Garfield County and the Haynesville Shale play in northern Louisiana. In 2012, he conducted two major deals, including a $2.9 billion sale of its Cutbank Ridge properties in British Columbia to Mitsubishi, and a $2.18 billion sale of its stake in some Duvernay assets to a subsidiary of PetroChina. But the latter took a considerable amount of work after the initial deal from February 2011—$5.4 billion for a 50 percent stake— collapsed in June of that year, leaving Eresman red-faced. At the time, CIBC analyst Andrew Potter said in a note to investors that the “failure to close this transaction will impact perception of management credibility.” Brillon says that in retrospect, the company should have continued to massage the initial deal instead of announcing it as a success: “Things were a lot more defined going into that secondary level of negotiations.”
Even with the PetroChina deal completed, Encana was in crisis. The balance sheet was in ruins, and Eresman retired on January 11, 2013 with hardly any notice. Clayton Woitas, former head of Renaissance Energy, was appointed interim CEO.
ERESMAN’S EXIT MEANT THE COMPANY HAD
to scour the landscape for someone who could right the company’s path. Some 150 names were compiled from around the world as a potential replacement for Eresman, including Brillon and two other internal candidates. Suttles eventually received the nod. On the same day the appointment was made public, Suttles announced the launching of a new strategy review that would be formulated by “seven of their best and brightest and future leaders in the company,” and would be implemented in 2014.
Launching the strategy was a grueling task. “We locked them in a windowless conference room, gave them incredible access to the organization and even brought in some outside stimulus—bankers and other folks—to give their own view of Encana and share their own ideas,” Suttles says. “And then they worked essentially over a four-month period, did a great deal of assessment of Encana and our strengths and our weaknesses and the oil and gas industry and what opportunities would be out there and what issues to manage.”
Brillon laughs when asked about the following months, describing the implementation process as “a whirlwind.” In addition to the redirection of capital from a sprawling 28 assets down to four, the company also underwent a complete structural overhaul, with the consolidation of departments and halving of the executive team.
For his part, Suttles quickly got to work. The new CEO brought in austerity measures to help balance its books, cutting 1,200 jobs in his first year at the company, and cutting assets down to four plays—the Permian, Eagle Ford, Duvernay and Montney—from 28. “We had people in the organization working on all 28,” Suttles recalls. “In some ways, they were measuring their success by how effective they were at attracting capital. It was about getting people to understand that this competing for capital was not the definition of success.”
In addition, joint-ventures were suspended, a move Suttles says that, while not permanent, is intended to ensure the company remains agile. PrairieSky Royalty, the company that retained freehold lands gifted by Canada’s first prime minister, was spun off in May 2014 for $1.46 billion, with a secondary offering made in September 2014 for $2.6 billion. Two days after the latter deal, Encana bought up the 30,000 boe/d Permian producer Athlon Energy for $5.93 billion in cash, which added to the June 2014 purchase of Freeport-McMoRan’s 53,000 boe/d acreage in the Eagle Ford. Despite criticism of the timing, Suttles says that Encana was both buying and selling assets at the same point in the price cycle, and that the timing allowed the company to pivot quickly and reduce the risk of buying and selling “at the wrong points of the cycle.”
DESPITE THE SEEMINGLY DISASTROUS TIMING
of the deal, some analysts are sympathetic to Suttles’ decision. “They came really close to picking the peak of WTI [in the Permian], and it went downhill from there,” says Brook Papau, managing director at RS Energy Group. “But their understanding of the Permian over that time, and the well results out of it, got better and better. So while oil was falling, Permian names were flat. And so they probably would have had to pay the exact same price six months later anyway.”
The company has certainly made the most of the new assets. By November 2015, Encana was posting a 36-percent increase in liquids from the year prior. In the first seven months following the acquisition, the company had stripped 24 percent out of its operating costs, putting it into the top tier of drilling completion costs and well production performance. Michael McAllister, the executive vice-president and COO of Encana, cites a combo of fit-forpurpose rigs, real-time bit design and experimentation with frack fluid rates and concentrations that allowed for the company’s technical improvements.
David Meats, an equity analyst at Morningstar, says the current challenge for the company is that they have “an infinite portfolio of high-quality well locations that they can’t drill quickly enough to add value.” If prices were at 2014 levels, he estimates the company would be doing three to four times the activity it’s doing now. “It’s almost like they’ve bitten off more than they can chew,” he says. “You can’t fault them for a strategy which made perfect sense given prices at the time of the transactions—but it was definitely bad timing in 20/20 hindsight.”
In March 2015, Encana issued $1.25 billion in equity to raise funds. Brillon says the company probably could have issued equity when it undertook the Athlon transaction but felt the market was still open and the opportunity to do an issue came forward (Cenovus collected $1.5 billion in share sales the month prior). The money was used to help pay down around $1.6 billion in debt.
In the months that followed, share prices continued to plummet, reaching a 13-year low in July 2015. Liquids production had almost doubled by that point compared to the year prior. Encana offloaded its Haynesville assets to GeoSouthern Paynesville for $850 million in August, and DJ Basin properties to the Canada Pension Plan Investment Board for $900 million. But values have since plunged to alltime lows, sitting at about one-third of the price of Cenovus shares. Takeover talk has been resurfacing in the financial blogosphere. Given the incredible strength of its asset base, there’s a case to be made that Encana could be a target (in April 2015, the Financial Post dubbed Encana and Cenovus as “the hunted”). Meats doubts such a possibility, saying that smaller firms are more likely to “roll over and disappear first,” a trait which he dubs “a natural defense mechanism” for Encana.
The company’s future is completely unpredictable at this point, given the tight grip that multi-year lows in oil prices have put on all producers. But Brillon ultimately remains optimistic. “We’ve been through a lot of cycles,” she says. “We’ve confronted a lot of issues. It’s really quite remarkable in my position that I’ve been able to look at a merger, a split, an IPO and a recasting of strategy as many times as I have. Lots of people don’t have that opportunity once in their career to do one of those things. I guess we’ll keep it coming.” For now, the made-in-Canada energy giant has little other choice.