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oil & gas

Could Encana Corp. and Cenovus Energy Inc. be two of the best buys in the S&P/TSX 60?

It's a funny question, given how oil prices struggle to top $50 (U.S.), half their levels of a year ago, with some commentators suggesting they could fall to the $30 range. It's also funny, given how both companies are diluting their shareholders by raising capital through share sales at today's depressed prices.

Of course, long-time shareholders may fail to see any humour in the question at all, seeing as how Cenovus shares have fallen 24 per cent in the past 12 months, with Encana tumbling 32 per cent.

For investors who see the energy sector's struggles as a medium-term issue, however, it's worth taking a look at these two giants of Canadian energy. While a number of analysts charged with making 12-month forecasts are neutral on the shares, others see a path to healthy returns by 2016. And the analysts at U.S. research firm Morningstar, who use a long-term assessment of "fair value" to evaluate shares, have given Encana a five-star rating, meaning it trades at a sharp discount to what Morningstar thinks it is worth. (Cenovus had a five-star rating but Morningstar has placed it under review while a new analyst takes over coverage.)

First, some history that may be familiar to many: Encana and Cenovus were once one. In 2009, Encana spun out its oil sands, conventional crude oil and refining properties in the vehicle it called Cenovus. That left Encana as a pure-play natural gas company, with extensive operations in the shale properties that were quickly becoming all the rage in the energy sector.

Morningstar analyst David Meats believes Encana has the best balance sheet in the exploration and production industry and is well-positioned to weather the downturn. Even more impressively, Mr. Meats says, is a series of transactions that have allowed Encana to move away from "second-tier resource plays with mediocre returns" to focus on more profitable plays where liquefied natural gas dominates. He says Encana management executed the strategy much more quickly than investors could reasonably have expected by selling off lower-quality properties and buying into the Eagle Ford and Permian basins.

"I hear analysts every second day putting out reports saying a piece of news as 'transformational' – it's a very overused word," Mr. Meats says. "But it's very appropriate in terms of what Encana did last year."

Mr. Meats estimates the fair value of Encana shares at $22 – the stock also trades on the New York Stock Exchange – versus Friday's American close of $11.63. Morningstar's energy analysts are currently using energy futures prices for the next three years in their model, then assuming $90 a barrel afterward.

Despite Encana's healthy balance sheet – or perhaps because of its desire to maintain it – the company said this week it would do a $1.25-billion (Canadian) "bought deal" share offering, with stock sold to underwriters at $14.60 a share. The company said it would use the proceeds, plus other money, to retire roughly $1.6-billion in debt on which it's paying interest rates of nearly 6 per cent.

Encana shares sunk this week on news of the deal, with the sale price about 10 per cent below the Feb. 27 close. While it's clearly preferable for a company to sell stock to the public when its shares are near highs, rather than lows, "Your stock price being high and your need for capital do not normally coincide," Mr. Meats says.

"Even though it's dilutive, it's very conservative, because they're patching up that balance sheet even more."

That's also part of the buy case for Cenovus, which just completed a similar share offering that also seemed to disappoint some investors. The company sold $1.5-billion of stock at $22.25 a share to pay for its 2015 capital expenditure program and repay some debts. (Friday's Toronto close of $22.05 is about 9 per cent below the closing price Feb. 13, the last closing day before the deal was announced.)

Mohit Bhardwaj of Citigroup Global Markets Inc., who has a "neutral" rating on the shares, cut his earnings estimates and target price on news of the deal; he suggests Cenovus should have done an IPO of some of its properties, given the valuation of PrairieSky Royalty Ltd. – another Encana spinoff. But analyst Nick Lupick of AltaCorp Capital believes a royalty IPO would be difficult for Cenovus in the current environment and calls the share dilution "the lesser of many evils." (Mr. Lupick has a "sector perform" rating on Cenovus shares, but its price has slipped sufficiently that his 12-month target of $26, when combined with a 5-per-cent dividend yield, produces a potential total return of roughly 23 per cent.)

Menno Hulshof of TD Securities, one of Cenovus's underwriters in the bought deal, resumed coverage March 4 and upgraded the stock to "buy" from "hold," with a $25 target price. With the offering, Cenovus "has managed to bring its balance sheet back into a comfortable range in line with its integrated peers" and addressed "the single largest risk to the story."

Investors who are deeply pessimistic about oil prices will probably consider the global energy market the single largest risk to both these companies' stories, of course. But with these stock offerings, both Encana and Cenovus are better able to weather whatever comes next. And if the future includes gains, not declines, in oil, these two stocks will follow.

Note to readers: After this article went to press, Morningstar said it was placing its energy sector coverage under review as it prepares to reduce its long-term price estimates for oil and natural gas, and, as a consequence, its fair value estimates for Encana, Cenovus and other energy companies.

On March 13, Morningstar revised its "midcycle" prices to $69 (U.S.) per barrel for West Texas Intermediate crude oil, down from $90, and $4 per thousand cubic feet of natural gas, down from $5.40. Encana retains its five-star rating, but Morningstar now gives Cenovus stock just two stars in its rating system.


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