Description

Mack885 posted a comprehensive writeup of Contango Oil & Gas Company (MCF) last July.  Since then, oil and natural gas prices collapsed, and MCF's stock price followed suit, dropping over 60%, creating today's opportunity.

Contango is selling at approximately 1.2x the PV-10 value of its PDP reserves valued at the current NYMEX strip, and has a free cash flow yield, net of development capital expenditures but before subtracting exploration and acquisition capex, of 14%.  This leaves an investor paying very little for Contango's development opportunities in the Buda formation in Dimmit and Zavala counties of South Texas and the Woodbine formation in Madison and Grimes counties of Southeast Texas, the potential of which was described in Mack885’s writeup.

Background.  Contango Oil & Gas Company, an oil and gas exploration and production company, was founded by Ken Peak in 1999.  Ken Peak was a master at capital allocation (a rarity in the oil patch), and Contango thrived under his stewardship.  However, in August 2012, Peak took a medical leave of absence from Contango, and passed away in April 2013

In January 2013, during Peak's leave of absence and before his passing, Contango began discussions with Crimson Exploration, a smaller E&P, concerning a possible business combination.  These discussions, which, from all available evidence, were conducted with Peak's support, resulted in Contango agreeing in April 2013 to acquire Crimson in an all-stock merger transaction.  The transaction closed in October 2013.

In the merger, Contango shareholders retained approximately 80% of the combined company and former Crimson shareholders received approximately 20%.  Joseph Romano (who assisted Peak in founding Contango in 1999, and who served as a temporary administrator of the Peak estate) serves as chairman of the combined company’s board of directors.  The balance of the combined company's management comes from Crimson:  Allan Keel, who was Crimson's chief executive, serves as the combined company's chief executive and Joseph Grady, who was Crimson's chief financial officer, serves as the combined company’s chief financial officer.  The board of directors of the combined company consists of four directors originally selected by Contango and three originally selected by Crimson.

At the time, the combination appeared to be a good deal for both parties.  Upon Peak's illness and passing, Romano became chief executive.  However, it appeared that Romano had neither the time nor inclination to become a fully committed public company CEO; therefore, Contango was in need of permanent senior management.  The merger provided Contango with Crimson’s executive management team.  To a certain extent, the transaction can be described as management succession by acquisition.

The merger diversified Contango’s asset mix.  While Contango’s legacy assets were predominately natural gas properties located primarily in the shallow offshore waters of the Gulf of Mexico, Crimson’s assets were onshore, and included oil and natural gas liquids-focused unconventional resource positions in several plays.  The merger was immediately accretive to Contango’s cash flow per share, and Crimson had large net operating loss carryforwards providing a tax shield for future earnings of the combined company.

For Crimson, the merger served as a deleveraging transaction.  Crimson carried high debt levels, which limited its financial flexibility and its ability to fully exploit its drilling prospects.  Conversely, Contango was debt free, held large cash balances, and generated considerable amounts of free cash flow.  The combined company's financial liquidity would enable it to accelerate the development of Crimson’s portfolio of onshore drilling prospects, funding the capital program entirely through internally-generated cash flow.  At least that was the idea at the time.

Oaktree Investment.  Crimson, then known as GulfWest Energy, was recapitalized in 2005 by Oaktree Capital Management.  In connection with the recapitalization, Oaktree acquired a controlling interest in Crimson, reconstituted the board of directors with its own nominees, and installed Allan Keel as chief executive officer and Joseph Grady as chief financial officer.  Since the recapitalization, Oaktree increased its investment in Crimson on two occasions.  Oaktree owns approximately 7% of Contango's stock, and an Oaktree representative serves on Contango's board of directors as one of Crimson's three designees.  Pursuant to registration rights granted to Oaktree in connection with the merger, Contango recently filed an S-1 for a secondary offering of Oaktree’s shares.

Reserves and Production.  As of December 31, 2014, Contango had approximately 275.2 Bcfe of proved reserves, of which 65% was natural gas, 18% was oil and condensate, and 17% was natural gas liquids.  As of May 11, 2015, Contango's production was averaging approximately 102 Mmcfed.

Properties.  Contango’s properties can be separated into three buckets:  Contango’s legacy offshore natural gas properties located in the shallow water Gulf of Mexico (GOM); Crimson’s legacy onshore assets; and Contango’s 37% interest in Exaro (a joint venture exploiting the Jonah Field in Wyoming).  The properties are briefly described below.  I encourage readers to review Mack888’s writeup for a more comprehensive review of Contango’s assets, especially the Woodbine and Buda plays

Offshore Gulf of Mexico.  Contango has thirteen Company-operated wells in the shallow waters of the GOM, producing from four fields.  The largest of these fields is, by far, the Dutch and Mary Rose field, which is producing from ten wells.  As of December 31, 2014, Contango’s offshore properties included proved reserves of 143.8 Bcfe, all of which were proved developed producing.  Even in today’s low price environment, these assets generate significant free cash flow.

Southeast Texas (Woodbine).  As of December 31, 2014, Contango’s Southeast Texas region included approximately 39,900 gross (23,000 net) acres, and proved reserves of 63.8 Bcfe.  This includes approximately 16,100 net acres in Madison and Grimes counties (approximately 50% of which is held by production), in which Contango is targeting the horizontal development of the oil and liquids-rich Woodbine formation.  Contango has a multi-year inventory of potential drilling locations in this area.  For 2015, Contango intends to complete eight wells initiated in late 2014, and drill one additional well to satisfy a farm-in commitment.  This is the only planned development activity for the entire company in 2015.

South Texas (Buda/Eagle Ford).  As of December 31, 2014, Contango’s South Texas region included approximately 165,800 gross (83,200 net) acres, and proved reserves of 53.7 Bcfe.  This includes approximately 41,300 gross (21,400 net) acres targeting the oil and liquids-rich Buda formation and Eagle Ford Shale (primarily in Zavala and Dimmit counties), approximately 70% of which is held by production.  Contango is planning no drilling in Zavala and Dimmit counties in 2015, pending improvement in the commodity price environment and/or the service cost structure.

New Projects.  In 2014, Contango initiated three new prospects, the Elm Hill project in South Texas, the FRAMS project targeting the Mowry Shale in Natrona County Wyoming, and the North Cheyenne project targeting the Muddy Sandstone in Weston County Wyoming.  Contango holds approximately 25,100 net acres in Fayette, Gonzales, Caldwell, and Bastrop counties, Texas, holds the right to earn approximately 69,900 net acres with a 60% working interest in Natrona County, Wyoming targeting the Mowry Shale, and holds the right to earn approximately 35,000 net acres with a 72% to 80% working interest in Weston County, Wyoming targeting the Muddy Sandstone formation.  Approximately one-third of Contango’s 2015 capital budget is being allocated to testing these prospects.

Other.  Contango also holds 7,400 gross (4,300 net) acres primarily in San Augustine County in East Texas, 69% of which is held by production.  This acreage is prospective for the dry gas Haynesville and Mid-Bossier Shales and, potentially, the liquids-rich James Lime formation.  Contango also holds approximately 16,100 gross (11,200 net) acres in the DJ Basin in Colorado (mostly in Adams and Weld counties), substantially all of which is held by production.  Contango is monitoring developments adjacent to its acreage, but has no current plans to develop it.

Exaro.  Contango owns a 37% equity investment in Exaro Energy III LLC that is primarily focused on the development of proved natural gas reserves in the Jonah Field in Wyoming.  As of December 31, 2014, proved reserves attributable to Contango’s investment in Exaro were 70.2 Bcfe.  Two drilling rigs are currently running on this project, which should remain the case for the remainder of 2015.

Capital Expenditures.  Contango’s projected capital expenditures for 2015 are approximately $50.6 million, which will be funded primarily from internally generated cash flow.  The budget is allocated as follows:  Approximately $17.2 million in development expenditures, to finalize the drilling and completion of several wells in the Woodbine formation; approximately $25.3 million in exploration expenditures, focused primarily on Contango’s Elm Hill project and Wyoming (Mowry Shale and Muddy Sandstone) projects, and also including a Lower Lewisville (Chalktown) and an Eagle Ford test well; and approximately $8.5 million for the acquisition of new leases and seismic data.

Contango expended approximately $31.7 million of its total capital budget in the first quarter, leaving a budget of approximately $18.9 million for the balance of 2015.

Debt.  Contango’s debt consists solely of a secured revolving bank credit facility with Royal Bank of Canada maturing in 2017.  As of March 31, 2015, approximately $104.5 million was outstanding under Contango's facility, with borrowing availability of $118.5 million.  Prior to the most recent redetermination, the borrowing base under the loan was $275 million.  Effective May 7, 2015, the borrowing base was reduced to $225 million.

Hedges.  Contango entered 2015 unhedged.  In April, Contango placed hedges on a substantial portion of its non-GOM oil production for the remainder of 2015 utilizing costless collars with a floor price of $55 and a ceiling of $65.  Consistent with its historical practice, Contango's GOM production is unhedged.

EBITDAX and Cash Flow.  In 2015, I am projecting EIBTDAX of $62.5 million (consensus is $99 million), discretionary cash flow of $60 million, and free cash flow of $10 million.  However, cash flow before exploration and acquisition expenditures is $40 million, for a cash flow yield of 14%.

Share Repurchases.  In November 2014, Contango issued a press release announcing that (1) Contango's lenders agreed to amend Contango's credit agreement to provide the authority to repurchase shares up to the remaining availability under Contango's $50 million share repurchase program and (2) the board had elected to resume the repurchase of shares under the program.  Following that announcement, Contango repurchased 205,457 shares at an average price of $35.89 per share, all in November 2014.  Since then, the company has not repurchased additional shares.  As of March 31, 2015, $31.8 million remains available for future purchases under the program.

On Contango's fourth quarter conference call, when responding to a question about share purchases, the CFO said as follows:

Well, you know, it's hard to go out and buy shares in a price environment that has no clarity to it. . . . Once we get some clarity on where we think the price environment might be for the remainder of the year and beyond and see where we are on our balance sheet and what impact the prices will have on borrowing base and so forth and so on and what our capex might be related to success we hope to have in our exploratory plays, we'll just have to take all of those factors into consideration in deciding whether to continue on our repurchase plan or not." 

I suspect Ken Peak would have responded differently.

Valuation.  At December 31, 2014, the PV-10 of Contango's proved developed producing reserves was $627 million, based on SEC pricing of $93.32 per barrel for oil, $4.32 per MMbtu for natural gas, and $33.45 per barrel for NGLs.  I reestimated the PV-10 value of PDP reserves using NYMEX strip pricing (averaging the price for the next twelve months) for oil and natural gas.  The prices used were $59.60 per barrel for oil, $3.14 per MMbtu for natural gas, and $20.00 per barrel for NGLs.

Risks.

I view capital allocation as the largest company-specific risk.  That Contango has ceased nearly all development drilling is encouraging, especially given management's stated reason:  in this price environment, it's better to leave the oil in the ground.

On the other hand, the exploratory capex being spent on the Elm Hill and Wyoming projects is troubling.  I understand that drillers have to drill, but either paying down debt or repurchasing shares seems a better use of capital.

Further, management has stated on numerous occasions since the oil price collapse that they are interested in using Contango's financial flexibility to acquire distressed assets.  However, it appears that every private equity firm in America is raising a fund to acquire distressed energy assets, making it, at least to some extent, a seller's market.  Further, anecdotally, the bid-ask spreads between buyers and sellers makes it difficult to do deals.  Management has acknowledged this reality, albeit reluctantly.  It is difficult to imagine that they will get a better deal in the D&A market than buying their own shares.

Catalyst

Good things happen to cheap stocks.