Energy analysts last week questioned Encana Corp.’s capital expenditure (capex) plans into 2012 after the unconventional natural gas giant failed to complete a $5.4 billion joint operating agreement with a subsidiary of PetroChina International Ltd.

The proposed joint venture (JV) to develop Encana’s gassy Cutbank Ridge property in northeast British Columbia (BC) and northwest Alberta was one of the most lucrative transactions announced this year by producers in North America. However, Encana CEO Randy Eresman said the potential partners were unable to agree on key elements of the operating partnership.

“After close to a year of exclusive negotiations with PetroChina, we were unable to reach alignment on the planned transaction,” said Eresman. The company now will look for a “variety of JV opportunities” for portions of the undeveloped resources and examine a separate deal for its midstream pipeline and processing assets in the area. An “array of potential investors” are discussing options, he added.

Encana and China National Petroleum Corp., which is majority stakeholder in PetroChina, last year signed a memorandum of understanding to negotiate a potential JV to develop acreage in the Horn River, Greater Sierra’s Jean Marie formation and Cutbank Ridge (see NGI, June 28, 2010). Eight months later the Calgary-based gas giant signed an agreement with PetroChina International Investment Co. Ltd. to negotiate a 50/50 partnership to “ambitiously grow natural gas production” in the region (see NGI, Feb. 14).

Because of confidentiality agreements Encana could not clarify why the negotiations had ended. Apparently there were “significant gaps in fundamentals,” according to spokesman Alan Boras.

Encana’s Cutbank Ridge resource play, in which it holds about one million acres, consists of gas production from the Montney, Cadomin and Doig geological formations. The producer would have shared production from 693,000 net acres of leasehold in the Montney formation, which has been producing since 1998. Last year Encana drilled a total of 62 net wells in Cutbank Ridge.

Using end-of-year 2010 numbers, the Cutbank Ridge JV would have provided PetroChina with half of the production and proved reserves, which amounts to around 255 MMcfe/d and about 1.0 Tcfe, respectively. The planned JV infrastructure, on a 100% basis, included about 700 MMcf/d of processing capacity, about 3,400 kilometers of pipelines and the Hythe natural gas storage facility.

Negotiations are “well under way” to find JV partners for acreage in the Horn River Basin, as well as a potential sale of assets in the Greater Sierra, said Eresman last week. In April he had detailed some of the JV prospects during a conference call (see NGI, April 25). “Each of these opportunities has the potential for strong long-term growth and value generation,” said the CEO.

Encana had planned to use some of the PetroChina investment not only to add cash to the bottom line but also to speed development of gas reserves and increase its liquids production in North America.

Following the news Standard & Poor’s Ratings Services (S&P) revised its outlook on Encana to “negative” from “stable.” Credit analyst Aniki Saha-Yannopoulos said without “the partnership and capital infusion, we are concerned about Encana’s capital expenditure plans amidst persistent weak natural gas prices…

“Given our expectation that increasing natural gas production from unconventional gas plays will continue to depress North American gas prices, we believe the company’s profitability and capital structure will be constrained,” said the S&P analyst. S&P expects Encana “to outspend its cash flow through 2012 and hence for debt to…remain elevated…in the near term.”

With low natural gas prices and a massive inventory of gas prospects, the inability to complete the JV is “certainly not good,” said UBS analyst George Toriola. “The money was supposed to help support Encana’s balance sheet. That’s now gone away so the balance sheet is looking stretched now.”

CIBC World Markets analyst Andrew Potter also said the news wasn’t a positive for Encana. The Canadian producer, he said in a note, had been planning to buy back $2-3 billion of its stock to boost the share price and keep the bottom line in good shape.

“While Encana’s balance sheet is still reasonable, the company is unlikely to pursue as sizable of a buyback, which is negative in our view,” Potter wrote. “Additionally, failure to close this transaction will impact perception of management credibility.”

Tom Driscoll’s analyst team at Barclays Capital said the announcement “re-raises” concerns about Encana’s (ECA) funding and growth.

“We estimate ECA to be $2 billion underfunded over the remainder of 2011 and 2012,” said the Barclays analysts. “This assumes average gas prices of $4.25/Mcf over the remainder of 2011 and $4.50 in 2012. We have assumed $8.1 billion of spending over this time frame and [a] dividend of $147 million/quarter. We estimate ECA could deliver mid-single-digit production growth with this amount of spending.”

The Barclays analysts “continue to believe ECA will struggle to grow volumes on a debt-adjusted basis as it manages around weak gas prices.” Encana is targeting a supply cost of $3.00/Mcf, which is down from its current cost of $3.70/Mcf; its long-term outlook for gas prices is $6.00/Mcf on average.

The dissolution of the PetroChina negotiations leads to more questions than answers, said analysts with Tudor, Pickering, Holt & Co. (TPH).

“We’re not experts” on Encana, said the TPH team, “but when a large gassy joint venture with an Asian company hits a snag, it gets our attention.” No reason was cited for the discussions falling apart, but Encana “has hired advisers to ‘unlock value’ from the Cutbank Ridge assets going forward…” Encana retained RBC Capital Markets and Jefferies & CO. to help find partners for other BC acreage.

TPH analysts questioned whether the lack of an agreement was “negative for Montney asset value” or whether foreign JV partners were “less interested in gassy North American assets.”

Robert Bellinski, who covers the Canadian upstream sector for Morningstar, said he suspected that “the degree of delineation drilling versus actual development activity” played a part in PetroChina’s decision.

“Looking forward, there is a fair degree of uncertainty surrounding Encana’s plans at Cutbank Ridge,” Bellinski wrote. “The firm now states that it is looking to form additional joint ventures, separate from infrastructure assets. We do not have a gauge on potential counterparty appetite for such deals, but note that, with the wealth of undeveloped Canadian acreage currently available for joint venture interests, this may be difficult for Encana to accomplish in the near term.

“As for PetroChina, we doubt the collapse of this deal will do much to diminish its appetite for foreign resources or its desire to gain technical knowledge. We anticipate it will continue to look for other opportunities to partner in Canadian shale gas development. We will be revising our Encana valuation model to reflect the loss of PetroChina’s deal proceeds, as well as Encana’s future development plans at Cutbank Ridge. At this time, we anticipate a reduction to our fair value estimate.”

In a research note Canaccord Genuity’s Phil Skolnick said the analyst would maintain a “hold” rating on Encana but cut the price target to US$31/share.

“We point out that we weren’t overly excited about the stock when the possibility of the big joint venture was first announced…and now there is even less reason to be bullish on it, in our view,” said Skolnick. Encana still might buy back about 5% of its outstanding shares but the number would have been larger if the JV had been completed, he added.

Encana now has a farm-out agreement in place with KOGAS Canada Ltd., a subsidiary of Korea Gas Corp., which has invested about C$565 million to explore a portion of the Horn River and the Montney. Last August South Korean producer STX Energy Co. also agreed to pay Encana US$144 million to acquire the Maxhamish natural gas field in northwestern Canada (see NGI, Sept. 6, 2010).

Although the potential JV is off the table, Encana reaffirmed its forecasts for 2011. It now expects to generate proceeds and JV investments of $1-2 billion this year, which exceeds an earlier forecast of $500 million.

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