The release of Encana's first-quarter results Wednesday set the stage for challenges facing natural gas-weighted energy companies.

Encana reported results that beat analyst expectations on production, cash flow and operating earnings, but by far the most interesting aspect was that dealing with hedging. If there was any doubt about the noise generated by accounting rules -- especially those with hedging exposure -- Encana's numbers were a fine example.

The company reported net earnings of $1.47 billion US -- an eye-popping, banklike number -- but that included unrealized hedging gains of $912 million. This means had the hedges been unwound in the quarter, that's the additional cash the company would have realized. But because they are still outstanding, they have to be subtracted from the net earnings number -- resulting in operating earnings of $418 million.

The company also realized some hedging gains in the first quarter -- amounting to about $160 million -- which helped its bottom line. Apart from showing the confusing nature of accounting rules, Encana's numbers show how important it is to hedge in the current market. Without a strong hedging program, it's tough to make money with natural gas trading at $4 per thousand cubic feet; companies will have positive cash flow but there won't be much extra to invest in ongoing capital expenditures.

The trouble is the hedging game is generally reserved for the big players -- which have active programs like Encana's that look out on a three-year time horizon; Encana has hedged one-third
of its 2012 production at $6.46 per mcf, with the existing hedges for this year and next offering similar coverage. Drop down into the junior ranks and hedging programs are rarely in evidence, although it's the smaller players that can be hit harder by the drop in commodity prices and an inability to carry out drilling programs. Some of that is because junior players attract different investors -- those interested in growth and who are willing to accept the attendant risk. The reality is the market doesn't pay for hedges that have been on the right side of the trade, while it is entirely unsympathetic when companies have made the wrong bet. Instead, the junior players will use their balance sheet just as some companies -- Encana among them -- use their hedging program to aid in funding capital programs.

The final piece to this, in the current environment, is that there isn't much in the way of hedging opportunities in the forward strip right now because of where natural gas is trading; it closed on the NYMEX at $3.96 per mcf on Thursday, while the 12-month strip is at $4.22 per mcf. There was a window -- back in December and in the early part of this year -- when companies could have locked in a $6 natural gas price, but the betting is not many took advantage of this. What they might have done instead was to raise money in the public markets or draw on existing bank lines. The trouble is that no one -- save for a few optimists -- is expecting the natural gas price to rebound significantly this year. In addition to the demand outlook, the other big question mark remains the trade-off between the shale gas production and first-year decline rates relative to the impact of the dramatic drop in drilling for conventional natural gas reserves

 Which makes Encana's strategy to double production in five years a bit curious in the eyes of some market watchers.

There's one school of thought that says the company is the low-cost producer, it has world-class assets and by drilling through the cycle it is positioning itself to take full advantage when a recovery in natural gas prices takes place. This is not unlike the strategies being carried out by the likes of Devon, Exxon- Mobil, Chesapeake and ConocoPhillips with their natural gas assets. There is, however, another view and it has to do with the basic laws of supply and demand. Encana, as the low-cost producer, can increase production, which in these markets potentially translates into downward pressure on natural gas prices. Low natural gas prices hobble the weak competitors and might just provide acquisition opportunities for the bigger companies -- which include Encana. This is certainly a more Machiavellian take on the company's strategy. Either way, there's no question Encana's strategy is a bold one in the current environment. And it's going to be interesting to see how other natural gas levered producers fare in the current reporting season.

dyedlin@theherald. canwest.com