The Manual of
Contango Oil & Gas (
) presents a compelling opportunity for investors willing to look
beyond the headlines of drilling bans and the current natural gas
glut toward a world that remains starved for energy. Emerging
economies continue to demand increasing amounts of oil and gas,
while true alternatives remain in their infancy. And with
commodities in general looking more attractive vis-à-vis easily
printed fiat currency, history may yet play out in a way that puts
Contango among the beneficiaries rather than the victims. Did we
mention the company is cheap?
Contango's high-margin, easily accessible, proved and developed
reserves of natural gas in the Gulf of Mexico can be seen as a huge
tank of gas that can be monetized in a predictable way, subject to
volatility in natural gas prices. Even at current depressed prices,
the company's value exceeds the market price. If we consider
Contango's capable and shareholder-friendly management, "free"
options on future exploration, and a debt-free balance sheet,
Contango becomes a compelling situation with low downside and
Contango - Cost Structure vs. Industry Average ($ per
The company's total cost per unit of natural gas equivalents
(Mcfe) is less than half the industry average. This enables
Contango to make money even in times of depressed natural gas
prices. The low cost structure is a testament to Ken Peak's sound
operating philosophy and able management.
click to enlarge
Note: Total cost structure includes operating costs
(including production taxes), interest expense, general and
administrative expenses, and DD&A for 38 companies followed
by Credit Suisse.
dated April 2010, The Manual of Ideas.
While we view Contango as a "good" business, we want to be
perfectly clear: No commodity-producing company is a good company
if "good" is defined as possessing pricing power due to product
differentiation or brand value. One firm's natural gas is as good
as the next firm's natural gas, so the only way to be a "good"
commodity producer is to be a low-cost producer. While many
companies claim to be low-cost producers, Contango actually meets
Depletion, depreciation and amortization (DD&A) is roughly
$1.25 per Mcfe. Adding this DD&A expense to cash costs such as
lease operating expenses and G&A, we arrive at an operating
expense of slightly more than $2 per Mcfe, before income taxes. As
a result, natural gas prices would need to drop to roughly $2 per
Mcfe to erase profitability (excluding dry hole costs). This is the
mark of a low-cost producer.
The near-term trajectory of natural gas prices remains
uncertain, but it seems reasonable to assume that prices will
increase from $4 per Mcf over time. Prices will likely need to
exceed $6 per Mcf for producers to earn a 10% return on capital,
according to UBS. Contango CEO Ken Peak estimates that industry
participants would earn 5-10% returns, on average, at $6 per Mcf.
In other words, the industry may be losing money from a full-cycle
cost perspective at recent natural gas prices. Contango's low cost
structure limits the downside, while natural gas price increases
would create material equity upside.
The following chart shows Contango's unusual efficiency. As the
per-employee data suggests, the company does business by
outsourcing almost everything to third parties (it just hired its
eighth employee!), except functions directly related to maximizing
value. Foremost among the latter are decisions on capital
allocation, i.e., buybacks versus exploration spending.
Contango - per-Share, per-Mcfe and per-Employee Operating
The company's financials reflect an industry-leading level of
efficiency and profitability.
EBITDAX = earnings before interest, taxes, depreciation,
depletion, amortization, exploration expense
* For the twelve months ended or as of March 31, 2010.
dated August 25 2010, The Manual of Ideas.
Contango's Ken Peak is a no-nonsense CEO and a shrewd capital
allocator. Unlike CEOs who have a habit of plowing free cash flow
right back into exploration projects, Peak evaluates the merits of
exploration versus other uses of cash, including acquiring
Contango's own reserves by repurchasing stock. Over the past year,
the latter option has looked attractive, and Contango has bought
back more than $50 million of stock, implicitly acquiring
high-margin reserves at roughly $2 per Mcfe. Finally, Peak is 64
years old, owns roughly 20% of Contango, and has been
opportunistically looking at selling the company at a large
premium. A deal almost came to fruition last year, but crumbling
natural gas prices and tight credit scuttled a sale, giving us
another bite at the proverbial apple.
Estimating the Value of Contango
Contango has no debt, $40 million of cash, and proven developed
reserves of 19 Mcfe per share. With the recent market price at $47
per share, we are paying slightly more than $2 per Mcfe of
high-margin reserves. This represents an attractive entry point,
even with natural gas prices trading at a depressed level of $4 per
Mcfe (December 2011 natural gas futures trade at roughly $5.50 per
Our analysis suggests a value of $1.0-1.7 billion, or $64-107
per share, based on the three valuation approaches summarized in
the following chart. This is the same methodology we have used in
the past, updated to reflect the latest available data.
Contango - What Are The Shares Worth?
We use three approaches to arrive at a valuation meaningfully
higher than recent market value.
Source: Company filings, Manual of Ideas analysis.
We judge Contango Oil & Gas to have strong downside
due to (1) a capable, shareholder-friendly, heavily incentivized
CEO, (2) a strong, deleveraged balance sheet, (3) a position as
low-cost producer in the natural gas industry, (4) a successful
exploration track record, and (5) an unusually disciplined approach
to capital allocation, including large, value-accretive share
Q&A on Contango:
Q: Contango has been a value investor favorite for the
past couple of years, but the stock has not performed as
expected. Why is this going to change?
There is, of course, no guarantee that Contango shares will perform
well in the future, but we view the risk-reward trade-off as
compelling. Given Contango's able and investor-friendly CEO and the
company's valuable proved and developed reserves, it is difficult
to envision a scenario in which shareholders suffer permanent
impairment of an investment at the recent stock price.
Meanwhile, the shares retain large upside potential, mainly due
to the company's potential desirability as an acquisition candidate
as well as management's demonstrated ability to add reserves at low
cost. We concede that Contango does not have the kind of equity
upside that a highly levered company might have.
Q: The company recently drilled two dry holes. Doesn't
this negate all the talk of exploration skill?
We don't think so. Contango's overall cost of adding new reserves
is still exceedingly low. CEO Peak put it well: "Disappointment
seems like too much of an understatement for one dry hole, let
alone two. Stepping back though, we are one for three in this
year's exploration program with a fourth well drilling (Eloise
South) and one more wildcat exploration well - our on-shore south
Texas prospect - planned prior to the end of this fiscal year…"
Contango's capex plan calls for the drilling of 4 wildcat GOM
wells at $15 million each and 15 ConterraJ/V wells at $1.5 million
per well, resulting in total capex of approximately $85 million
before any success capex. The company is able to fund this capex
organically, as it has $40 million of net cash and monthly pre-tax
cash flow $15 million. The company expects to spud the first GOM
well offshore Texas (permit in hand) in mid October.
Q: What is the impact of the GOM oil spill on
The company put out a
on the oil spill impact on May 6th, in which it stated that there
was no immediate impact to Contango. However, neither the company,
nor anyone else, can accurately predict what the government might
do in the short and long term with regard to regulatory
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