Encana (NYSE: ECA) is a large exploration and production (E&P) company based in Canada. While it produces both oil and natural gas, the company’s efforts are focused more heavily on natural gas operations across North America.

Over the past few weeks (see TES, October 12, 2005, A Look Back, A Look Ahead) I’ve outlined the case for more near-term downside in energy prices and some energy stocks.

I must stress once again that this doesn’t change the long-term secular case for energy stocks. Ultimately, corrections like this will offer a buying opportunity. And, as I’ve detailed, certain groups will continue to perform well even if energy pulls back.

But there’s another way to play the short-term downside: by shorting stocks most vulnerable to a decline in commodity prices. Encana fits the bill–I recommend shorting the stock above 46 with a stop-loss at 53. I’ll continue to track this trade via Flash Alerts and in regular TES issues as a trade recommendation.

There’s nothing wrong with Encana’s reserve base, but the company is a high-cost producer. There are a few key reasons for this. One has to do with the geology of some of Encana’s main reserves. To produce these reserves effectively, Encana drills what are known as infill wells. Basically, if it originally drilled a series of wells 10 miles apart, the company might come back and drill an infill well, in between the two existing wells.

I’ll highlight this geological problem and explain infill drilling in more depth in an upcoming issue. Suffice it to say this requires drilling more wells to produce a given reserve.

Unfortunately, as I’ve highlighted on several occasions, the North American drilling market is ultra-tight right now and day-rates for both land and offshore rigs are very high right now. There is also a shortage of experienced crews. I’ve listened to more than a few conference calls where management teams blamed drilling delays and problems on inexperienced drilling crews. That means that drilling all those wells is getting increasingly expensive and subject to delay and rig shortages.

On the service side it’s no better. While Schlumberger (NYSE: SLB), Weatherford (NYSE: WFT) and BJ Services (NYSE: BJS) are raising prices for various services–a long-term positive for the services stocks–companies like Encana have to pay those higher costs. And Encana is a service-intensive operation because it has to drill more complex well designs. These rising costs will continue to eat away at profitability and if commodity prices come down a bit further (as I expect) the squeeze will be even more apparent.

I recommend you short Encana here; I’m looking for 15 percent downside or so over the next three months.

Finally, please note that ConocoPhillips (NYSE: COP), Cooper Cameron (NYSE: CAM) and Denison Mines (NYSE: DEN) have all hit my recommended stops. ConocoPhillips and Cooper Cameron were both stopped out for nice gains and Denison is out for a small loss. Stand aside from all three for now as we’re still likely a few weeks away from a better buying opportunity. (See TES, October 12, 2005, A Look Back, A Look Ahead, for details.)