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Contango Oil and Gas (NYSEMKT:MCF) is an exploration and production company in pursuit of mainly natural gas in shallow waters of the Gulf of Mexico. The E&P business is typically a terrible one to be in, but Contango is an exception. Contango is run by Ken Peak. Ken is a straight-talkin', cost-cuttin', Warren Buffett quotin' CEO. From the 10K:

Our exploration strategy is predicated upon two core beliefs: (1) that the only competitive advantage in the commodity-based natural gas and oil business is to be among the lowest cost producers and (2) that virtually all the exploration and production industry’s value creation occurs through the drilling of successful exploratory wells.

When you're in a pure commodity business, there is really only one way to get ahead (or stay in business), and that is to be the lowest cost producer. Contango/Peak focus all of their energy on this.

Contango has an extremely lean cost structure. They have just 7 employees (How many companies with a market cap of nearly $700 million can say that?). They have no debt, so no interest expense (almost unheard of in their industry). They operate less than a dozen wells, so they all benefit from scale. All wells are in the Gulf of Mexico, so they only have one landowner/regulator, the MMS. A lot of the gas in the GOM is naturally liquified, as opposed to shale gas that has to go through a costly process to liquify. Their wells also deplete at a much slower rate than shale reserves. They also outsource everything except for exploration, where most value is created. If it is a cost, Peak wants to eliminate it. Contango's costs are so low, their largest expense is taxes!

All this translates into a total cost of about $2.25-2.50 per mcf of natural gas. According to Credit Suisse, the average cost for the industry is around $5.50 per mcf. This means that the average E&P needs nat gas at $6 just to get a decent return (10%). When nat gas gets under $6 and companies hedges eventually come off, then they will basically stop drilling because they cannot make money. This reduced supply will eventually push prices up again.

Because Contango is the lowest cost producer, they do not hedge. Natural gas can be half of the average nat gas company's breakeven point, and Contango is still making money. Therefore, gas rarely, if ever gets cheap enough for contango to lose money drilling. Contango doesn't have to protect downside risk by hedging (because there is none long term), and they can enjoy all the upside potential. Besides, if gas is so cheap that contango cannot make money drilling, then likely their share price is very depressed. In this extreme case, they can just buy back shares and still earn a very good return. This happened during the market turmoil of late 2008/ early 2009, when the company bought back 7% of their stock at an average price of about $42 and change (not too much lower than today). They were essentially buying back their own proven reserves at $1.75 MCF a share when they are likely worth about $3.5 per share in normal times at (a 50 cent dollar).

Aligned Interests

Ken Peak and other managers have most of their net worth in Contango, and Peak owns about 15% of it. He takes great pride in Contango's accomplishments over the years. He has turned about $30 million in seed capital into about $700 in market cap in about one decade. He also hasn't taken stock options in 3 years, and is quite proud that Contango was able to grow assets to eye popping levels with virtually no debt and the same share count as 10 years ago. Peak even names Contango's reserves after family members. Peak got divorced a few years ago and told his ex-wife to just take his salary and leave him all the stock. So bottom line, management interests are aligned with shareholders.

Valuation

The after tax PV-10 of their proven reserves is $40 per share at $4.5 nat gas prices (which I consider depressed prices) and excess cash is about $3 per share. The stock is currently trading at about $43 per share. However, I don't see gas staying at $4.5 long-term.

In the years leading up to the financial crisis (basically 2004-2008), M&A for gas reserves (including shale plays) were on average valued at $3.5-4 per mcf. Contango's reserves are of higher quality than those reserves because they are larger wells (economies of scale), they are completely developed, and they have less depletion than shale. And yet the market is valuing these reserves alone at less that $2 per mcf.

Contango was also up for sale about 2 years ago, and apparently Peak got an $80 offer for just the Dutch and Mary Rose reserves, but he didn't take it because he considered it too cheap and no other offers were made as the market/nat gas prices were starting to fall off a cliff.

If nat gas goes any lower then the company will start to buy back shares again, and if nat gas goes higher then shareholders will do very well. This gives no value to future potential discoveries (aka growth in book value) and undeveloped reserves. Book value per share has grown in every year except one since MCF's inception, attributable to Contango's excellent business model and Peak's leadership. In 2001 Contango had just over 11 Bcfe in reserves, and now they have over 300 bcfe. Contango just drilled a successful well called Eloise south.

With Contango's amazing drilling success rate and Peak's focus on only drilling when there is a good risk-reward, Contango's future is bright (and free). It's not every day that you see a best of breed company that is growing book value at an eye popping pace with no signs of slowing, and yet you can buy them at a slight discount to current depressed book and a major discount to normalized book value. Put a different way, it's not every day that you can buy a company with very low downside risk and very high upside potential.

Note: Recently, Contango uncovered new data on their Dutch and Mary Rose field reserves. It was determined that the reserve tank was smaller, and the amount of reserves were downwardly revised 15%. However, the reduction has little effect on present value because it effects the heavily discounted out years. Meanwhile, Peak said that he and all other employees will forfeit their options/bonus for this year, which softens the blow even more. The stock fell more than 5% the day it the revision was announced, making the event more than discounted in Contango's current price.

Disclosure: Author long MCF

Source: Contango Oil & Gas: A Bright Future for Free