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Contango Oil & Gas: Safe & Cheap

 Contango Oil & Gas is currently trading at $48.5 and has around 16.5 million fully diluted shares outstanding. The company focuses on the highest part of the value chain in the natural gas market, which is exploration. The CEO, Ken Peak, believes that the only competitive advantage in the natural gas industry is to be among the lowest cost producers. He also believes that the way to create value in the industry is through drilling successful wells and his main focus is on value creation per share. The company has a very lean operating structure with only 8 employees and they outsource their exploration to a company called Juneau Exploration. Juneau has a 66% historical hit rate when it comes to finding oil and gas versus the average 33%. The company was successful in finding 2 of the largest natural gas finds in the Gulf of Mexico in the past 30 years. The company currently has 350 Bcfe of proven producing developed reserves and just found another 90 Bcfe in their last wildcat well. This totals to 440 Bcfe for a company with only an 800 million market capitalization.

My Net Present Value (NYSE:NPV) Microsoft Excel model gets a current value of $67.87 per share. This assumes the long run average natural gas price at the Henry Hub of $7 per MMBtu. This is conservative because the industry’s marginal cost of production is around $6 and they need 5-15% RoR to make it worthwhile to drill. Contango’s natural gas is 1080 BTU so they can sell it at an 11% premium to the Henry Hub and additionally they sell some higher margin oil and NGL’s. The CEO has told us that the life of these reserves is 10 years, which means they will be flowing at 120 Mmcfe per day or 44 Bcfe per year.

If we assume no more wildcatting and only count proven producing developed reserves, Contango currently trades at 71% of NAV and has very limited downside. Its limited downside comes from its lowest cost producer status. They are profitable down to $2.39 per mcf at the Henry Hub versus $6 per mcf average of large natural gas producers. Ken Peak currently owns 21% of the outstanding shares so he is highly incentivized to increase the stock price. He has done this successfully in the past, achieving a 61X market cap/net invested capital ratio for the decade. Additionally the company has no debt, $70 million in cash and a $50 million unused revolver.

The company has significant upside from the DCF price due to its active $100 million repurchase program. Additionally, the company has a significant amount of Gulf of Mexico leases that could mean large future gas finds from wildcatting as Juneau has a 66% hit rate. Since Contango is unhedged, there is great upside from a potential black swan event in the natural gas industry where prices could shoot up to the $10-$15 mcf range. In fact, prices did hit $14/mcf in 2008. Finally, the CEO wants to sell out in the short to medium term given his age and his past attempt to sell the company where he achieved bids in the $70 to $80 range. However, he will only sell out at a fair price which was evidenced by his instituting a poison pill rights plan after opening up his books to investors right before the natural gas price collapsed from $14 to $3.

Variant View

This stock is not followed by any analysts which is why this mis pricing exists. The stock has a small market cap and is not covered by many large funds. Additionally, the stock has very concentrated wells which may scare some people who like more diverse companies. Finally, natural gas is very out of favor as people are moving more into oil and other commodities.

Disclosure: Long MCF