Description

Contango Oil and Gas (MCF) continues to ramp up drilling in its high IRR acreage while it trades at a large discount to comps and remains dirt cheap on an absolute basis across almost every E&P metric.  Owing to a variety of reasons including lack sell side coverage, over-diversity in geography, and the transformation of the company from “old Crimson” to “new Contango,” investors ignore MCF.  Drilling down on the company reveals excellent acreage, aggressive high IRR drilling programs, upside optionality in developing plays, and the financial flexibility execute.  Unlike some smaller competitors, MCF is not a private equity vehicle disguised as an E&P company. Contango is very much in control of its own destiny with over 80% of its wells company operated and almost no debt.    Putting figures to its inexpensive valuation, investors are purchasing the company at 3.5x 2014E EBITDA, 0.87x 12/31/13 proved PV-10, $44K/current boepd, and $4.8K/unadjusted acre.

Brief History

Contango today is a significantly different set of assets today than it was a year ago.  In October of 2013, the shallow GOM gas focused driller Contango completed a merger with Texas focused onshore E&P, Crimson Oil and Gas.  The Contango name stuck while the legacy Crimson management team took over the operations of the company.  The rationale for the merger was reasonably straightforward despite the seemingly unrelated collection of E&P assets.  Crimson owned a great assemblage of oil weighted acreage in South, East and Southeast Texas but was significantly over-leveraged.  Contango was sitting on a cash pile while looking for oil exposure in order to diversify away from its shallow GOM gas focus in a $3 handle gas environment.  The net result of the merger is an unleveraged E&P company using the cash flow from its offshore assets to fund drilling in the Buda in South Texas, the Woodbine in East Texas, and the James Lime in East Texas.

Asset overview

Buda (Zavala/Dimmit counties) 50% Working Interest

The two most important regions and driving force for increased production are the Buda in Dimmit/Zavala counties of South Texas and the Woodbine in Madison/Grimes counties of East Texas.

The Buda play benefits from uniquely naturally fractured geology, allowing horizontal wells to be completed open hole (without hydraulic fracturing).  Well costs have declined to approximately $2mm per well from an already low cost of $4mm per well over the past year.  MCF’s partner in the Buda acreage, U.S Energy (USEG), estimates IRRs of 214% based on the old $4mm cost and the very high oil cut (90%+).  While USEG incorporates higher EUR estimates than MCF (400Mboe vs. 250Mboe), halving well costs keeps those IRRs in the upper stratosphere regardless.  It is a somewhat statistical play, with a mix of great and just okay wells driven by hitting more or less of the natural fractures. Contango should complete 20 wells in 2014 with 2 rigs currently operating in the region. Contango continues to test methods of output improvement including dual laterals and possible well stimulation. Management has repeated many times the Buda offers the highest cash on cash return of any play in the country.  The good wells pay back in under 2 months and take only about a month per well to drill and complete.  Since MCF and USEG are the only public companies focusing on the region, it has largely been missed by Wall Street while private operators Sage and Dan Hughes pioneered the play.  Contango originally purchased the Dimmit/Zavala county acreage to drill the Eagle Ford but switched gears when Dan Hughes hit a “super Buda” well a mile from its border.  Contago is currently revisiting the Eagle Ford in the same acreage with a new KM Ranch well being drilled. USEG estimates their 30% working interest in MCF’s Buda is worth $140-280mm and the calculation was based on old well costs of $4mm vs the current $2mm figure.  Adjusted for MCF’s 50% working interest and lower well costs puts the potential valuation over of the Buda over $500mm for MCF, an estimate that loosely foots to MCF’s investor presentation slide estimate of unproved potential of the Buda.

Woodbine (Madison/Grimes counties) 80% Working Interest

The Woodbine is Contango’s other aggressive drilling play.  Within the three areas named Force, Chalktown and Iola/Grimes, they have over 20 producing wells with 20 completions planned across 2014.  Much like their Buda region, MCF has quickly reduced the per well cost structure with new wells coming in closer to $5mm down from the $10mm they spent on the first few.  IRRs have not been fleshed out by the company, but a good guide could be Gastar’s Lower Hunton type curve that produces 75% IRRs based on very similar EURs and costs. (EUR of 436Mboe 5.2mm costs, 65% liquids). Management thinks they have at least 130 locations left to drill. Across the same acreage, a variety of other operators have been successfully drilling both Eagle Ford and Georgetown wells.  MCF has no plans to allocate capital to non-Woodbine wells in 2014, but they project they could have 216 and 112 locations respectively.  The current PV-10 of the Woodbine is $265mm, however management pencils out an additional $1bn of unproved potential in their Madison/Grimes acreage.  The 20 wells in 2014 puts them on a path toward achieving both significant reserve growth and cash flow.

Offshore (shallow GOM) 60% Working Interest

Legacy Contango’s shallow Gulf of Mexico operations comprise the offshore component of Contango 2.0.  With a PV-10 of $555mm (98% Proved Developed) and current production of 76.1mmcfe/d, the offshore operations provide ballast to MCF’s valuation and cash flow to fund onshore drilling.  After drilling a $35mm dry hole so far in 2014, Contango management has hit their self-imposed GOM spending limit.  There are currently 6 existing shallow water prospects left on the drawing board, however management does not have an appetite to exploit them aggressively.  Recall that management is largely the former Crimson team, meaning they are not so skilled in offshore endeavors.  Since the initial Crimson/Contago deal was largely done to fix Crimson’s balance sheet and management has an overabundance of onshore opportunities, it would be value creative for offshore assets to be monetized. To be clear, Contango management has not articulated any intent to monetize offshore assets.  An additional potential benefit of would be an immediate bump in valuation for becoming a pure play onshore E&P.  Miller Energy (MILL) experienced a 20% price increase last month by announcing its intent to sell its onshore Tennessee assets to be a pure play Alaska offshore.    

James Lime (San Augustine/Sabine counties) 60% Working Interest

In MCF’s 4,800 net acres of San Augustine/Sabine counties, the first two wells were very recently completed to very encouraging results. The Kodiak #2H IP’s at 834 boe/d and the Fairway Farms #1H shows 525 boe/d production in its first full month on the Texas Railroad Commission reporting site. At an initial price of $8mm/well, costs would need to come down to the targeted $6-7mm range generate acceptable IRRs, but the oil (60%) is clearly present and in line with Devon Energy’s 10 wells in the area.  Further, Contango management has demonstrated its ability to lower well costs dramatically in both the Buda and Woodbine. 

Tuscaloosa Marine Shale (TMS Louisiana) 72% Working Interest

After taking a 25% non-operating working interest in GDPs first successful TMS well, Crosby 12H-1, MCF management purchased approximately 30,000 net acres in the play. While they have no near plans to peruse a drilling program, shareholders should benefit from Goodrich Petroleum’s $300mm of 2014 TMS drilling capex.  GDP’s pure play TMS trades at $4.3K/acre unadjusted for production and $2.3K/acre adjusted for $60K per flowing boe/d. However, those figures should increase as GDP puts up more 1,000+boe/d wells and demonstrates it can take cost/well from $13mm to $10mm.  MCF is effectively has no value ascribed to this asset in it reserves nor its market cap.  The TMS could be a $130mm+ value for MCF shareholders.

Niobrara (Colorado) 70% Working Interst

Yet another unrecognized option tucked into Contango is its 11,200 net acres position in the Niobrara. It is 100% held by production and management has 1 possible well planned for 2014 that would run $5.5 ($3mm net) with an expected EUR of 400mboe.  Niobrara pure play PDC Energy trades at $10.5K/acre unadjusted for production or $6.3K/acre adjusted for $60K per flowing boe/d. Like the TMS, the Niobrara is effectively absent from MCF’s reserves, but it could be another $115mm+

Valuation

So what is this hodgepodge worth? Precision with respect to a valuation of Contango is likely a futile endeavor.  As far as the downside is concerned, it is assuredly worth more than proved reserves of $1bn, which drastically underestimates the Buda, Madison/Grimes Woodbine and provides no value for Niobrara and TMS.  On an EBITDA basis, Contango is the cheapest E&P I have encountered at 3.5x vs other SMIDcaps in the 7x+ range.  Contango has nominal debt and $240mm of projected 2014 EBITDA, allowing it to fund its aggressive $220mm of drilling capex out of cash flow.  The result should be increased proved reserves and increasing high IRR free cash flow.  Management believes converting its unproved potential into reserves would create a PV 10 of $3.4bn.  Such a valuation appears reasonable with respect to the drilling success to date and the long runway of wells, though at current MCF pricing, half of that realization would be a homerun.

Catalyst