The mad dash to tap the massive natural gas and oil shales across North America has begun to cut into the bottom line as service costs rise, Encana Corp. executives said Wednesday.

Speaking with energy analysts about the company’s performance in 1Q2010, Jeff Wojahn, who helms Encana’s U.S. division, said, “We see the storm clouds coming,” when asked about costs to drill onshore.

CEO Randy Eresman noted that energy prices make up about 15% of Encana’s capital costs, and they are rising as is the cost of drilling and fracturing horizontal wells. Encana, which now explores exclusively for North American unconventional gas, is Canada’s largest gas producer and one of the most prolific drillers onshore in U.S. shale and coalbed methane basins.

To hold large leaseholds spread across the Haynesville Shale in Louisiana and Texas, Encana and its peers are rushing to drill acreage. U.S. gas shale drilling, which has failed to slow as much as energy analysts had predicted last year, has led to more demand for oilfield service companies that provide the drilling and completion work to free gas from deep shale deposits.

“We’re in this situation where a number of the pumping services companies worked at very low-cost structures last year to keep their crews busy,” said Wojahn. “Today they’re seeing higher demand and they’re asking for increases.”

Because Encana has most of its long-term contracts sewn up and most of its steel purchased for 2010, it basically is shielded from rising costs this year, said Eresman. Rising costs also have yet to impact the Calgary producer with inflation in its U.S. operations at less than 1% in the first three months of the year. In addition, efficiency gains in its drilling operations have more than offset cost increases for now.

However, with its company now a pure-play gas producer, any cost jumps are a worry.

“Inflationary pressures are becoming a concern to us,” said Eresman. “One of the things in the longer term for what inflation typically does is it translates into higher commodity prices.” Margins may be maintained with inflation. “But I wouldn’t want to count on that, and we see that the best way to manage inflation is by continually inputting operational efficiencies.”

In any case, the current natural gas prices are “unsustainably low given what it costs to balance a normal market,” said the CEO. “Therefore, we plan to invest based on what we believe to be a more sustainable long-term price. Over the long term, we are confident that we can profitably grow production as we work to capture market share from higher-cost producers.”

Encana used gas hedges to overcome weakened gas prices in 1Q2010, and its quarterly profits jumped to $1.48 billion, which was three times what it earned in the same period of 2009. The company’s cash flow reached $1.2 billion ($1.57/share) in the quarter; operating earnings were $418 million (56 cents/share).

Revenue in the first three months of 2010 fell to $3.54 billion from $3.68 billion in the year-ago period. Commodity price hedges contributed $125 million in realized after-tax gains, or 17 cents/share, to cash flow.

At the end of last year Encana had an estimated 125 MMcf/d of gas production shut in in some U.S. and Canadian operations. It still has around 25 MMcf/d shut in, and that should be back on line by mid-year. Overall production reached an average of 3.3 Bcfe/d in 1Q2010.

“With production averaging about 3.3 Bcfe/d in the first quarter, we are on track to meet our 2010 guidance, and in line with our long-term goal of doubling production per share in five years,” Eresman said.

With 12.7 million net acres of leasehold across North America, Encana’s North American natural gas portfolio holds an estimated 12.8 Tcfe of proved reserves plus another 16 Tcfe of “low estimate economic contingent resources, using forecast prices,” the producer said. Given its inventory of gas resources, “the best value creation opportunity for shareholders is to accelerate development with a long-term goal to double production per share over the next five years,” the company said.

“By accelerating our development pace, we are advancing value recognition of our huge natural gas resource inventory,” said the CEO. “At the same time, we are ever mindful that during periods when low prices occur, we may need to act to preserve the value of our assets, which could include production curtailments not unlike those we employed for a period in 2009.”

Encana has built an “enormous natural gas resource inventory” in the past several years, Eresman said, and “we are now in the early stages of bringing together years of technical breakthroughs, advanced manufacturing practices and operational expertise through the gas factory development approach on our key resource plays.

“Still early in their development, gas factories accelerate development, optimize efficiencies and lower environmental impact by enabling the drilling of scores of horizontal wells, each containing multiple hydraulic fractures from a single pad location.”

Last November Encana completed a major corporate reorganization, which resulted in the company’s transition into a pure-play natural gas company and the spin-off of its integrated oil and Canadian Plains assets into Cenovus Energy Inc. (see Daily GPI, Nov. 30). To provide more useful comparative information, Encana’s quarterly results associated with the assets and operations transferred to Cenovus were eliminated from Encana’s consolidated results. The actual financial results for the comparative 2009 period are included in the company’s interim consolidated financial statements.

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