Contango Oil & Gas MCF
December 24, 2008 - 9:19am EST by
2008 2009
Price: 46.90 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 780 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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The best-run E&P I've ever found has an EV roughly equal to 60% of liquidation value of its producing, high-margin U.S. reserves.  And that's using current recession-is-here forward oil & gas prices.  The company owns 360 bcfe of natgas (20% oil and natgas liquids) in two discoveries just 7 miles off the Louisiana coast.  These reserves are easy to value and are rapidly turning into cash as production ramps up.  I expect they'll spend most of that cash on share buybacks, some of it on exploration (which they're really good at), and the rest will just pile up.  The balance sheet is solid with $53M cash and no debt. 

Sorry if that intro sounds promotional, but I want to make it clear that this is not the typical value-destroying E&P.  Contango's focus is natural gas exploration, and more specifically, on the capital allocation involved.  Drilling targets are generated via two JVs whose partners include a prospect shop called Juneau Exporation, seismic companies, and experienced E&P investors.  All drilling, development, etc. is contracted out. 

Tangible book per share for FYE June 30,:
 2000 2001
 $0.63 $2.18

As you can see, this somewhat unusual model has worked well for shareholders.  The growth in economic value is even better than this, since GAAP property values are based on their very low historical finding & development costs and they don't capitalize dry-hole costs.  So let's put it this way: Contango has parlayed a total of $50M in outside equity capital into a company with a $780M market cap today, and it's probably worth about twice that.  Their recent finds certainly account for a lot of that, but keep in mind that they've also had a number of very successful plays in South Texas and the Fayetteville Shale, plus a homerun investment in an LNG terminal.  Further, they did all this using very little debt.  CEO/Founder Ken Peak is a guy who gets fearful when others are greedy, plus he's got basically his entire net worth on the line (~14% of the shares outstanding). 

In 2006-7 Contango made the largest discovery on the Gulf of Mexico continental shelf in 25 years  - 961 bcfe, of which they own just under 40%.  Technically, it's two discoveries: "Dutch" in federal waters, and "Mary Rose" in adjacent Louisiana state waters.  Once the size of the find became clear, Peak tried to sell the company and simultaneously spin off the other properties (a handful of relatively tiny wells and 76 leases in the shelf) into a new public entity.

Peak's timing looked good with gas trading in the double digits.  He had hoped to wrap things up by September, but gas prices fell off a cliff in July/August and the company called off the sale after failing to get an acceptable bid.   I suspect that financing issues played a big role in this.  Buyers will typically finance a big chunk of the deal with debt, and the lenders will require them to hedge forward some of the production.  With gas prices in free-fall, I imagine the bidders worried about where they'd be able to hedge post-sale.  Wells in the Gulf produce very quickly and there's really no 15-30 year production "tail," so lousy hedges can really ding your ROI. 

Apparently they did get an $80/share offer for the Dutch and Mary Rose assets, not for the corporate entity.  An asset sale would have meant a tax bill for Contango and cut the proceeds to roughly $61/share.  I think the free-fall action in natgas is pretty much the driving factor behind that number.  Maybe the credit crisis jacked up borrowing costs too - I don't really know.  All I can tell you is that for someone who doesn't have to worry about financing (like, say, Contango), I can't see a plausible scenario where D&MR are worth only $61/share.  Basically we'd be talking about $6 gas and $50 oil forever.  My DCF model gives me an aftertax PV-10 of ~$75/share on 17.4M fully diluted shares at current futures pricing (roughly $7.50 gas and $65 oil).  (Note that I'm modelling out the original development plan, which they could always revert to if desired.  My model usually comes within a few % of the company's own published valuations, which I believe were based on said plan.  More on this later.)

The M&A history for the shelf lead me to the same conclusion.  The table below shows every major deal since early 2005 that I could find for gas-weighted GOM shelf assets: 

Val $M
Proved bcfe
Pct. gas
 2/23/05 Sumitomo
NCX Company II
 6/13/05 Helix
Murphy Oil
 1/2/06 W&T Offshore
 4/19/06 SGY, APC, ME
BP 1,300
 5/16/06 Coldren, First Reserve, SPN
Noble Energy
 4/2/07 Itochu
Range Resources
 6/21/07 McMoRan
 12/28/07 Mariner
 4/30/08 SGY
Bois d'Arc
 (implied) -- Contango
Keep in mind that it's tough to find good comps for the Gulf.  This isn't like valuing shale plays where you can have cookie-cutter economics across a wide swath of acreage.  Here, wells can have substantially different production costs, oil/gas ratios, production half-lives, etc.  Also, these metrics don't capture probable and possible reserves.  On average, I'd guess that D&MR are worth more per proved mcfe for three main reasons: 
  • First, they're 100% developed - i.e. no need to spend more money on drilling, pipelines, etc. 
  • Second, the operating costs are very low.  You get economies of scale with giant wells - they can flow nearly a Tcf of reserves through just one platform of their own and a portion of someone else's platform.  Their platform is operated by just one guy, it's just been built, and it survived hurricanes Gustav and Ike with minimal damage.  And the wells are in 11 feet of water only 7 miles offshore, whereas the continental shelf extends 200-300 miles offshore and up to 650 feet deep. 
  • Third, they're new wells, meaning the cash comes back to you faster.  Most gas wells show steeper declines in the early years, so the half-life (time to produce half the remaining reserves) is shorter.  I think most of these comps involve a much larger number of wells, some of which have been producing for a while.
On the flip side, Dutch and Mary Rose don't come with any probables or possibles.  The reserves are really close together, meaning a hurricane that passed right over your partners' downstream infrastructure could cause a long production delay.  And the deal size may have been a bit large for the typical independent E&Ps that have been consolidating the shelf (the supermajors aren't growing their presence here).  I think some of Contango's partners were also selling in the deal.

Where to now?
Maybe D&MR get sold later, but for now the company is content to buyback stock, pile up cash, and drill a few wildcats.  The beauty of this situation is that we can be confident that the cash flow will not be wasted - can't always say that in cyclical industries with depleting assets.  A lot of E&Ps will plow all their cash flow right back into the ground whether it makes any sense or not.  In the short run, Wall Street tends to reward constant reserve replacement and growing production more than tougher-to-calculate growth in value per share.  Plus, most E&Ps have in-house geology, geophysics and operations guys they want to keep busy.  Finally, there's a tax deferral from drilling new wells.  Put these together with some excessive optimism and cost inflation and the result is often sub-par returns.

But with only 6 employees, Contango doesn't need to create work for people.  It's self-financing and doesn't need to play Wall Street games.  And the CEO has basically the same risk/reward as we do.  There are no "founder well participation programs" or related party nonsense like that.  So now that this company finds itself with more cash than ideas we don't have to worry about them drilling stupid wells.  If that means having to pay some taxes, so be it.  Contango has been a tax payer from the early days, which is rare.

Right now they're drilling one rate acceleration well.  The original plan - I believe - was to drill 5 of these and really maximize the NPV of this gas, but that was before the market offered them their own reserves at a steep discount.  The IRR on buybacks is higher, so they're doing that instead. Gas prices might also influence this decision - Peak is clearly bearish on natgas in the near term due to rising production coupled with the recession.  So why rush to produce if we might be getting only $5/mcfe next summer?  ($5 being the ugly scenario, and not one that is likely to last.)

Exploration downside probably small, upside big (?)
Contango has no official plans to drill more wildcats beyond the 3 scheduled for 2009.  My hunch is we'll see more in 2010, but not a huge amount.  They'll skip the EI 56 East well if EI 56 West is dry, so worst case scenario is they spend $1.80/share on dry holes in 2009.
Contango's partner Juneau Exploration has historically found commercial amounts of gas in about 2 out of 3 wildcat wells in the GOM shelf, their area of expertise.  The industry average is 1 out of 3.  From 2000 to date, I count 14 successful wells out 20 wildcat wells.  Prior to that, Mr. Juneau was head of exploration at Zilkha Energy, which drilled about 56 successful wells out of 86 wildcats from about 1992 through 1997.  I'm only aware of one program in which they ventured outside the GOM shelf - Contango's South Texas Exploration Program (STEP) - in which I count about  52 drills, 40 hits and ~100 bcfe.

Importantly, these finds have been pretty big on average - I calculate averages of 15 bcfe at Zilkha and 83 bcfe at Contango.  It's worth noting that they also found South Timbalier, a 300+ bcfe deposit that prior to D&MR was the biggest shelf discovery since the early 1990s.

Their focus is now on the "deep shelf" - i.e. wells below about 15,000 feet.  This is more or less a new frontier as seismic and drilling technology have only recently begun to master the challenges of finding and operating at this depth.  The biggest finds are made in the early years of a new play, so it's exciting stuff.  I doubt they're drilling for anything less than 20 bcfe, and there are probably a lot of ~40 to ~100 bcfe deposits down there.  (100 bcfe at a 68% NRI and $3.60/mcfe = ~$14/share.)

Natgas pricing not such a risk in the long run
I don't worry much about gas prices for two reasons: first, because the pain of lower prices will likely be offset by the benefit of repurchasing stock.  Capex in 2009 should be roughly covered by cash on hand.  I expect 8/8ths production of 345 mmcfe/d once the Dutch #4 well comes online.  Even at $5/$50 gas/oil, that's $150M+ 2009 cash from operations to spend on a stock with a $780M market cap (or perhaps sub-700 in that scenario).  

Second, because low prices beget high prices, and with natural gas it doesn't usually take that long.  Yes, shale production is rising, we could see more LNG, it's a recession, etc.  But this industry really is on a treadmill - production of existing wells declines each year by over 1/3, and there's no way to replace that production without drilling a lot of shale at all-in costs of $7-8/mcfe at the margin.  Drilling will slow when gas trades below that, and a 1/3 natural decline rate pressures supply rather quickly.  If we did see $5 in mid-2009, it's possible we could see great prices by year end. 

A technical note:
Contango's largest investor, Sellers Capital (~16%) recently announced they'll be winding down operations.  Their Contango shares, however, are subject to a long-term lock up and Sellers intends to hold out for fair value, which they've publicly estimated to be $80-110/share.  So I'm not worried about some big overhang on the shares.

Peak had planned to be Chairman but not CEO of the aborted spinoff - said he wanted to slow down a bit and work on his golf game.  That and his age (63) make me think he'll wind this thing up at some point, and I expect he'd do it as tax-efficiently as possible.


Value becomes clear as the gas turns to cash
VIC members uniformly ignore this writeup, allowing company to buy back lots of shares on the cheap
CEO fully/semi-retires, resulting in a full/partial liquidity event for all shareholders
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