Contango (AMEX: MCF) runs on two principles:
(1) The only competitive advantage in the natural gas and oil business is to be among the lowest cost producers
(2) Virtually all the exploration and production industry’s value creation occurs through the drilling of successful exploratory wells
Kenneth Peak, the founder and CEO of Contango is the largest shareholder in the company, has never sold a share and is a very good capital allocator (Buffett type). He has 6 full time employees, all focusing on the highest ROI part of the E&P value chain – exploration. Every other service in the chain is contracted out to an expert that can provide better value for that part of the chain than MCF can. They work with some of the brightest and most successful oil and gas finders in the business. Contango collaborates with a network of about 10 geoscientists with four small, privately held alliance partners. In all their deals, the alliance partners have capital at risk and the deals are structured so that the partners do not make money before Contango makes money. This strategy has paid off - Contango made the largest Natural Gas find (Dutch and Mary Rose) in the Gulf of Mexico (GOM) in the last 2 decades, combing through old publically available data. Contango has the best balance sheet in the E&P sector, with approximately $50 million cash, another $50 million line of credit and $18 million in debt. They have 369bcf in proven reserves and 70 undrilled GOM leases. The Dutch and Mary Rose wells, when operating at full capacity, generate approximately $20 million per month in after-tax cash flow at $7 natural gas and $70 oil prices. The firm has also carved out some properties before and sold them for 10-15x their initial investments, all without paying tax (capital allocation).
The current stock price of approximately $43/share buys 22 mcf of Natural Gas and contemplates $4 natural gas prices and $50 dollar oil. I believe it is not possible for the price of natural gas to remain below $6 for a long period of time (I am not saying it will go up, but below $6 econ 101 will kick in) due to the high cost of marginal supply. MCF can purchase after-tax reserves on the open market, in the form of share repurchases, for approximately $1.75/mcf, which is about half of the cost of developing new reserves through drilling. The company has recently done some buybacks (again capital allocation) but any further buybacks will substantially increase the value of the company.
Warren Buffet has talked about the 'finding costs' as the most important factor in valuing Oil and Gas companies. Contango has total costs (including finding) of $2.18/mcf and is one of the lowest cost explorers in the GOM. The company’s PV-10 valuation with $7.00/mcf of natural gas and $70.00/bbl oil, NYMEX prices flat forever after 35% for projected federal income taxes is approximately $1.3 billion or $78.00 per share. The firm recently got an offer between $75-85/share just for the Dutch and Mary Rose fields (there are other fields, leases and a computer system worth around $10-20/share), but it fell through because of financing. Reserves in the GOM area have traditionally gone for $3.50-$5/mcf; with all these valuation metrics Contango is worth somewhere between $80 - $ 110/share. I am not saying this is the best deal in town (there are E&P companies which have 3-5x potential, but there's more risk) but that there is high visibility and therefore low risk. They have a tangible asset value that can be realized easily and the assets can be easily converted into cash without discounting them.
Mark Sellers has talked about this idea in the Value Investing Congress conferences many times. I researched it and always liked it but Contango never had the margin of safety before, now it does.
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