Description
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
|
2002
|
2003
|
2004
|
2005
|
2006
|
2007
|
2008
|
| $0.63 |
$2.18
|
$2.78
|
$2.23
|
$2.93
|
$3.80
|
$4.17
|
$5.69
|
$20.33
|
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.
Valuation
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:
Announced
|
Buyer
|
Seller
|
Val $M
|
Proved bcfe
|
Pct. gas
|
$/mcfe
|
| 2/23/05 |
Sumitomo
|
NCX Company II
|
144
|
70
|
100
|
$2.03
|
| 6/13/05 |
Helix
|
Murphy Oil
|
164
|
45
|
80
|
$3.65
|
| 1/2/06 |
W&T Offshore
|
Kerr-McGee
|
1,030
|
345
|
74
|
$2.98
|
| 4/19/06 |
SGY, APC, ME
|
BP |
1,300
|
120
|
53
|
$3.75
|
| 5/16/06 |
Coldren, First Reserve, SPN
|
Noble Energy
|
625
|
162
|
74
|
$3.86
|
| 4/2/07 |
Itochu
|
Range Resources
|
155
|
40
|
90
|
$3.87
|
| 6/21/07 |
McMoRan
|
Newfield
|
1,100
|
327
|
70
|
$3.36
|
| 12/28/07 |
Mariner
|
StatoilHydro
|
243
|
52
|
87
|
$4.64
|
| 4/30/08 |
SGY
|
Bois d'Arc
|
1,800
|
335
|
55
|
$5.37
|
| (implied) |
-- |
Contango
|
727
|
360
|
80
|
$2.02
|
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.
Finally,
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.
Catalyst
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