MRC Global: A Play on Oil & Gas Recovery

MRC Global is the largest distributor of pipes, valves, fittings, and related products and services to the energy industry.  The company was founded in 1921 as McJunkin Supply Company and grew organically and through acquisitions over the years.  In January 2007, Goldman Sachs Capital Partners acquired a controlling interest in McJunkin and in October 2007 merged the company with Red Man Pipe & Supply Company.  Over the next four years, several acquisitions were made in a strategy to “roll up” a number of smaller players in the distribution market.  In January 2012, the company’s name was changed to MRC Global and Goldman Sachs took the company public in April 2012 at $21 per share.  Shares of the company fell dramatically in late 2014 and 2015 due to weakness in oil and gas exploration.  Shares have recently been purchased by Fairholme Capital.

Oil Rig Counts

MRC Global’s business prospects are highly correlated with exploration and production activities which, in turn, are very sensitive to the level of commodity prices.  Starting in late 2014, the price of crude oil has been very weak and extremely volatile.  Crude oil prices below the marginal cost of production in many areas has resulted in rig counts collapsing over the past year.  Although MRC Global has international operations, 79 percent of revenue in 2015 was attributable to the United States with an additional 7 percent from Canada.  As a result, examining rig counts for the United States and Canada will shed the most light on industry conditions that most directly impact the company’s revenue.

Baker Hughes publishes extensive data on rig counts as a service to the petroleum industry.  The website is well worth perusing for anyone interested in the dynamics of the industry.  Data are presented in granular formats showing activity by region, well type, and resource plays.  For our purposes, it is sufficient to look at North American rig activity at a fairly high level.  The exhibit below shows the rig count in the United States over the past sixteen years:

US Rig Count Since 2000

As of April 22, 2016, there were 405 rigs operating on land and 26 rigs operating offshore.  This represents a 54 percent decline from the rig count one year ago and a 77 percent decline from two years ago.  The current rig count is at the lowest level in the history of the chart and far below the average level of slightly over 1400 rigs.  During the oil price collapse concurrent with the financial crisis, the oil rig count bottomed at 876 rigs in early June 2009, a level that is more than double of today’s rig count!  To say that the industry is in a severe depression could be an understatement.

The situation in Canada is also extremely depressed as we can see from the exhibit below.

Canada Rig Count Since 2003

The chart shows much more volatility due to seasonal factors in Canada that limit the level of drilling activity during the annual spring thaw.  However, it is obvious that the level of peak activity in 2015 was far below the peak level of any of the prior years in the chart.  Only 40 rigs were active in Canada on April 22, 2016, which is roughly half of the rig count one year ago.

Although the price of crude oil has recovered significantly since the lows of the first quarter, rig counts have not yet responded to higher prices perhaps because the current price of oil is still below the marginal cost of production for many E&P companies.  Additionally, many debt heavy E&P players are in severe financial distress and might not be in a position to quickly resume production unless prices rise significantly from current levels.

In contrast to the depressed state of the North American industry, the level of activity in international markets has not fallen as precipitously.  Baker Hughes publishes global rig count data.  Activity in certain locations with a low marginal cost of production, such as the Middle East, has shown no meaningful reduction.  However, with only 14 percent of MRC Global’s revenue coming from outside the United States and Canada, stability in international markets will not be a major factor in the company’s success in the near term.  MRC Global’s revenue will be highly sensitive to the future trends in the charts shown above.

Operating Performance

MRC Global had total revenue of $4.5 billion in 2015 which represents a 24 percent decline from 2014.  Revenue declined in all three of the company’s segments which are organized by region.  Canada was particularly hard hit with a revenue decline of 47 percent.  The exhibit below shows the company’s revenue broken down by geographic reporting segment:

MRC Global Revenue

The decline in revenue was also evident in all product lines sold by the company but particularly notable in the oil country tubular goods category.  This business is directly tied to drilling activity in the United States and is characterized by high volatility and extremely low margins.  MRC Global disposed of the tubular goods business in February 2016 and posted a loss associated with the disposal in 2015 financial results.  The exhibit below shows the breakdown of revenue by category in 2015.

MRC Revenue by Category

In general, the distribution industry is characterized by relatively low operating margins.  MRC Global has historically realized its best operating margins in the United States segment with more modest performance from Canadian and International operations.  During times of healthy drilling activity, such as 2012 through most of 2014, it appears that the company can generate operating margins in the 5 to 7 percent range.  In 2015, significant goodwill write-downs in the United States and International segments resulted in an operating loss.  Excluding goodwill impairments, the operating margin would have been 4 percent for 2015.  The exhibit below provides a summary of operating results since 2010:

MRC Global Operating Results

Gross margins have generally been in a range of 17 to 18 percent in recent years and management has indicated that gross margin in the high 17 to low 18 percent range is likely for 2016 as well.  The company’s income statements for the past seven years appear in the exhibit below.

MRC Global Income Statement

Free Cash Flow and Capital Allocation

One of the interesting characteristics of the distribution industry is that working capital requirements decline along with drilling activity which generates operating cash flow in years like 2015.  Both inventory and accounts receivable decline when business slows which makes cash available and provides some degree of operational flexibility.  The business has low capital requirements other than the maintenance of enough inventory to satisfy the demands of customers.  As a result, traditional capital expenditures are relatively minor.

As we can see from the income statements above, MRC Global posted a net loss of $345 million in 2015.  However, free cash flow was a positive $651 million.  The goodwill and intangible impairment of $462 million was a non-cash charge that turned what would have been an operating profit into an operating loss.  Additionally, both inventory and accounts receivable balances declined, partially offset by a decline in accounts payable.  Operating cash flow was $690 million and capital expenditures were $39 million.

Over the past five years, the company posted cumulative free cash flow of $919 million, well in excess of reported net income of $112 million.  A significant portion of free cash flow was used to fund acquisitions using $583 million over past five years.  It should be noted that the large goodwill impairments in 2009 and 2015 could be signs that management has overpaid for acquisitions in the past.  On the other hand, both impairments were taken in years when the price of oil declined to low levels and resulted in low rig counts.  Accounting rules require such write-downs even if long term prospects might be more favorable and goodwill that is written down can never be “written up” in future years.  Ultimately, management’s track record with respect to acquisitions will be measured based on free cash flow generation.

The exhibit below is taken from MRC Global’s investor presentation (pdf) at the BB&T Capital Markets 10th Annual Commercial & Industrial Conference on March 24, 2016 and illustrates the company’s use of cash flow over the past six years along with acquisitions since October 2008.

MRC Acquisitions


Capital Structure

MRC Global’s capital structure is currently less leveraged than it has been historically.  Management used the strong free cash flow in 2015 to pay down significant debt.  Additionally, convertible preferred stock was issued in June 2015.  Net debt was reduced by $974 million in 2015, a reduction of 68 percent.  Currently the only long term debt is a $524 million loan due in 2019.

Although balance sheet risk has been reduced over the past year, the terms of the preferred stock offering may not be favorable to owners of the common stock in the long run.  The 6.5% cumulative preferred is convertible into common stock at $17.88 per share.  While this is above today’s quote, it is likely that the preferred stock will eventually convert to common stock once rig counts increase and business prospects improve.  As a result, it is probably a good idea to simply assume dilution when analyzing the company.  The share count can be expected to increase by 20.3 million if the preferred stock is converted in full.  With shares outstanding of 102 million as of December 31, 2015, conversion would represent slightly under 20 percent dilution.

We would note that the working capital reductions that made strong operating cash flow possible in 2015 despite the industry downturn will certainly reverse once business conditions improve.  MRC Global will need to direct significant capital toward inventory and an increase in accounts receivable.  It appears that the company should have the financial flexibility to increase working capital once business conditions begin to improve although this might require adding leverage to the balance sheet.

Book value per share was $9.35 at the end of 2015 but tangible book value was close to zero so shareholders cannot rely on any tangible downside protection from a balance sheet perspective.  Shares recently traded at around $14 at a market capitalization of approximately $1.4 billion.


As the largest distributor of critical components and services to the oil and gas industry, MRC Global plays a very important role in the energy economy.  The business is highly correlated to drilling activity as represented by rig counts.  The collapse in energy prices caused rig counts to decline precipitously in 2015 (continuing into early 2016) and this had a major impact on MRC Global’s financial results.  However, management used strong free cash flow primarily generated through working capital reductions to deleverage the balance sheet.  A preferred stock offering, although potentially dilutive, further reduced the company’s risk profile.

MRC Global is not a wonderful business but it is an important business in a very important industry.  If rig counts remain depressed throughout 2016, MRC Global’s financial results will remain depressed as well and it is possible that further write-downs of intangible assets will be required.  Market sentiment would be negative under such conditions and the stock price is also likely to be correlated to the price of oil.  Eventually, supply and demand dynamics should result in a more normalized level of production in the United States and Canada.  The key question is when this “eventual” outcome will materialize.

As long as MRC Global does not face financial distress before a recovery commences, the share price should eventually recover along with industry activity.  The main risk appears to be a prolonged downturn with rig counts remaining at very low levels.  Investors who believe than energy prices will recover over the next couple of years might want to consider MRC Global, or other large distributors such as Now Inc., rather than investing in oil directly or through E&P companies.

Disclosure:  No position in MRC Global.

The Facts Change at Contango Oil & Gas

Contango Oil & GasOver the past several months, Contango Oil & Gas Company shareholders have received a steady stream of bad news.  The most significant development was the medical leave of absence and subsequent death of Kenneth R. Peak, the company’s founder and longtime Chairman and CEO.

Mr. Peak was a unique figure within the oil and gas industry and was often referred to as the “Warren Buffett of oil and gas” based on his plain spoken manner, straight forward management style, and constant attention to the creation of shareholder value.  In our limited interactions with Mr. Peak and his management team, it was clear that the company has been run in an unusually shareholder friendly manner.  Mr. Peak’s obituary in the Houston Chronicle provides further details regarding his many accomplishments.

We wrote about Contango several times over the past four years and published a bullish write-up on the company in September 2012 one month after Mr. Peak’s leave of absence began.  We encourage readers to review that write-up prior to proceeding since we will not repeat most of the financial details here.  Although Mr. Peak’s illness was obviously serious, we felt confident that the shares continued to provide good value due to the company’s oil and gas reserves, our view of the management succession plan, significant insider buying, and an extremely conservative balance sheet.  Unfortunately, several subsequent events have significantly chipped away at each of these pillars of the investment thesis.  In this article, we will take a look at the most important changes that have taken place over the past few months and assess whether the shares still represent a conservative commitment of capital.

Reserve Impairments

Over the past two quarters, a disturbing trend of reserve impairment has developed at Contango:

  • As of the date of the latest 10-K on June 30, 2012, the company reported 257 Bcfe of proved reserves with a PV-10 of $730.2 million.
  • For the quarter ended September 30, 2012, a relatively minor impairment of 2.2 Bcfe was recorded. This was followed by an additional impairment of 20.7 Bcfe for the quarter ended December 31, 2012 bringing the total impairment for the first half of fiscal 2013 to 22.9 Bcfe, or nearly 9 percent of the proved reserves reported to be in place as of June 30, 2012.
  • The company has produced approximately 13 Bcfe over the first half of  the fiscal year leaving reported reserves at December 31, 2012 at 221 Bcfe.
  • In a presentation announcing the acquisition of Crimson Exploration (more on this later), the company stated that proved reserves as of March 31, 2013 stood at 196 Bcfe and PV-10 was $572 million.  The decline from December 31, 2012 clearly signals additional impairments in the latest quarter since production rates cannot fully account for the 25 Bcfe decline.

Contango’s next 10-Q, expected to be filed later this week, should provide details on the nature of the latest impairment.  The exhibit below shows Contango’s proved reserves on an annual basis since 2000 along with proved reserves as of December 31, 2012 and March 31, 2013.  All figures are from the company’s 10-K filings except the figures for December 31, 2012 and March 31, 2013 which come from the company’s latest 10-Q and the Crimson merger presentation respectively.

MCF Proved Reserves

One of the risks facing Contango shareholders has been that the company’s proved reserves are concentrated in its Dutch and Mary Rose field as noted in the risks section of the latest 10-K.  Unfortunately this risk has materialized during the current fiscal year:

The Company’s reserves and revenues are primarily concentrated in one field.
Approximately 89% of our proved reserves are assigned to our Dutch and Mary Rose discoveries which have ten producing well bores concentrated in one reservoir and are producing through two production platforms. Reserve assessments based on only ten well bores in one reservoir are subject to significantly greater risk of being shut-in for a variety of weather, platform and pipeline difficulties. In addition, the risk of a downward revision in our reserve estimates is also greater.

Contango has recorded impairments to proved reserves at the Dutch and Mary Rose fields in the past.  On June 10, 2010, a 48.5 Bcfe downward revision was announced by the company with Mr. Peak also announcing that he and the management team would receive no bonus payments for the fiscal year as a result.  In contrast, it is unfortunate that shareholders had to learn about the reserve impairment in the latest quarter only by being alert enough to draw inferences from a slide during a merger presentation.

Crimson Exploration Merger

 On April 30, 2013, Contango announced that it would acquire Crimson Exploration in a all-stock transaction in which each share of Crimson would be converted into 0.08288 shares of Contango resulting in Crimson shareholders owning 20.3 percent of the post-merger Contango.

The value of the shares to be issued in the transaction was approximately $147 million at the time the deal was announced.  In addition, Contango will assume Crimson’s $244 million of debt.  Although Contango is clearly the larger company and the acquirer in this transaction, Crimson Exploration’s management will run the combined company once the deal closes.  We will not provide a full overview of the merger terms in this article but interested readers can access the merger presentation for a condensed overview and we also recommend reading Crimson’s latest 10-K report.

Major Strategic Shift

The Crimson acquisition represents a major strategic change for Contango.  Contango has historically been focused on oil and gas exploration in the Gulf of Mexico and has avoided unconventional shale plays with the exception of a few joint ventures that have not been material to the company’s valuation.  Crimson, in contrast, has focused on unconventional onshore oil and gas exploration.  As Mr. Peak’s many presentations over the years made clear, the economics of drilling in the Gulf of Mexico have been far more attractive over time because discoveries produce very low cost reserves.

We encourage readers to review Mr. Peak’s last presentation given just prior to his medical leave of absence last August.  In particular, slide 11 on Gulf of Mexico economics shows how the overall economics of Contango’s historical approach has added low cost profitable reserves for shareholders as evidenced by slide 4 pointing out that Contango’s recent cost per Mcfe was in the $2.68 to $2.86 range — a level that produced profits even in the depressed natural gas market that has prevailed in recent years.  In contrast, Crimson’s costs per Mcfe came in at $8.57 for the latest quarter according to a recent press release.  Leaving aside the overall economics or valuation for Crimson, it is clear that the operating models of the two companies have been quite different.

The rationale for the merger is that the combined company will have a more diversified mix of reserves with Contango’s offshore low cost reserves balanced by Crimson’s unconventional onshore reserves.  The strength of the combined balance sheet should also allow more Crimson prospects to be drilled since the limiting factor would no longer be Crimson’s highly leveraged capital structure.  Another advantage stated by both management teams is that the risk profile of exploration for the combined company will be lower since riskier offshore exploration will be balanced by onshore exploration with much higher success rates.

It should be noted that the strategy outlined in the merger presentation never seemed to appeal to Mr. Peak in the past and he often emphasized the superior economics of a Gulf centric exploration program.  Volatility in periodic results did not appear to bother him very much.

Crimson’s Management

While Contango shareholders may have been less than thrilled with the idea of issuing shares near a multi-year low in order to acquire Crimson, one can only imagine the horror of Crimson shareholders when they learned that they would be bought out at around $3.19 per share.  Crimson management has regularly made promotional presentations in which “net asset value” was calculated at many multiples of the prevailing share price.  Curiously, all of these presentations appear to have been removed from Crimson’s website which now only has the merger presentation posted under the presentations section.  However, we have obtained the latest Crimson presentation which was made on April 17, 2013, less than two weeks before the merger announcement.  Here is the relevant slide on valuation (click to enlarge):

Crimson NAV

Rather than jumping for joy as Contango shareholders at the great value we are apparently receiving, we instead cringed at the idea that our future management team would feel it appropriate to present a highly promotional estimate of “net asset value” less than two weeks before announcing a deal in which their shareholders would be compensated at a tiny fraction of this figure.  Although all of the usual warnings and caveats were presented by management and this probably covers them from a legal standpoint, the ethics of the situation is most troubling.

Crimson’s management emphasized the “premium” they were receiving for stockholders during the merger call even though shares had only recently traded above the agreed price and, apparently without any irony, affirmed that Crimson shareholders would be able to benefit from growth in the combined entity since the deal was an all-stock transaction.  Of course, the combined company would have to appreciate many-fold to even begin to make up for the low sales price relative to management’s claimed “net asset value”.

It should be noted that Crimson’s top management will come out of the transaction in good shape taking over management of the combined entity with attractive employment agreements for the CEO and CFO.  All Crimson stock options will also vest and convert to Contango options using the merger exchange ratio.  This is very generous treatment for a management team that presided over enormous destruction of shareholder capital at Crimson.

The Facts Have Changed

“When the facts change, I change my mind. What do you do, sir?”

— J.M. Keynes

Investing in oil and gas exploration companies is always an inherently risky endeavor and Contango was never an exception to this reality of the industry.  However, the company had a number of unique attributes that appeared to stack the odds in the investor’s favor.  The most important of these attributes included that fact that the company had a history of successful exploration that led to the creation of very low cost reserves in the Gulf of Mexico and had able and honest management in place with a strong shareholder orientation.  In addition, the company’s ultra conservative balance sheet made it almost unique in the industry and was attractive for those who did not wish to compound the inherent risks of oil and gas exploration with balance sheet risk associated with a heavy debt load.

Unfortunately, most of the underlying pillars upon which our investment thesis was based have been weakened over the past several months.  While Mr. Peak’s leave of absence and death was clearly a major negative from the perspective of shareholders, the trend of reserve impairments and the Crimson merger represent even larger warnings signs.  Contango’s reserves are concentrated in one field that now has a history of reserve impairment and could face additional impairments in the quarters and years to come.  The company has now had two CEOs since Mr. Peak took a medical leave and while we were comfortable with both CEOs and the rest of the management team, we are completely uncomfortable with Crimson’s team which will take over after the merger is complete for the reasons mentioned previously.

But Isn’t Contango “Stealing” Crimson a Positive Development?

Contango may very well be “stealing” Crimson based on the acquisition price if the proved reserves and reserve potential advertised by Crimson turns out to be accurate and if Contango’s balance sheet can reduce debt service costs and allow for additional drilling of the most promising Crimson prospects.  The combined company will have 311 Bcfe of reserves and a PV-10 of $932 million based on the merger disclosures.  Pro-forma enterprise value is roughly $900 million and debt as a percentage of total capital should be around 24 percent which is still quite conservative.  In addition, the combined company will have about $100 million in tax losses that can be used to offset future taxable income.  A case can certainly be made that the risk/reward scenario is compelling for continuing shareholders.

Never Back Into a Position

The bottom line is that we consider the combined Contango/Crimson entity under the management of Crimson to be a fundamentally different entity than the pre-merger Contango sharing few of its financial qualities and even less of its management philosophy.  Therefore the company must be evaluated as if it were a candidate for a new investment.  The alternative is to “back in” to the position by default which is always inadvisable.

Warren Buffett has on many occasions advised investors to not own a stock for ten minutes if they would not be willing to own it for ten years.  With Mr. Peak running the show, Contango clearly passed the test.  This did not guarantee results but shareholders were reasonably well assured that the results of their investment would roughly match the change in the company’s intrinsic value over long periods of time.  This is manifestly not the case with Crimson’s management team.  We are quite sure that Crimson’s management will, in ten years time, be materially richer than they are today.  We are equally uncertain about the fate of continuing Contango shareholders and therefore prefer to look elsewhere for investment opportunities.

Disclosure: No position in Contango Oil & Gas or Crimson Exploration

Contango Oil & Gas: Compelling Opportunity for Natural Gas Bulls

Contango’s Vermilion 170

Oil and gas wildcat exploration has never been for the faint of heart.  Modern exploration techniques require significant capital investments and the regulatory climate has become more of a burden over the years.  Even with advanced technology, projects are often more likely to fail than to succeed yet the lure of mineral riches is enough to attract significant capital to the industry.  The long period of depressed natural gas prices has led many value investors to consider exploration and production (E&P) companies but often significant balance sheet risk exists which can reduce or eliminate downside protection.

In too many cases, taking a position in a E&P company is more of a speculation than an investment due to leverage, hedges requiring derivatives that are difficult to evaluate, and the prospect of significant dilution due to the use of stock options.  In this article, we look at a unique E&P company that is conservatively run, free of leverage, hedges, and stock options, and offers investors a compelling value proposition at the current quote.

A Remarkable Success Story

Contango Oil & Gas Company is an independent natural gas and oil company focused on exploration, development, and production of resources primarily in shallow waters of the Gulf of Mexico.  The company was founded in 1999 by Chairman Kenneth Peak and has compiled an remarkable track record over the past thirteen years.

Mr. Peak has been referred to as the “Warren Buffett of natural gas” and for good reason:  With $79 million of invested capital, he has built a company with a recent market capitalization of $785 million and has returned over $115 million to shareholders through repurchases.

In mid-August, Contango announced that Mr. Peak would take a medical leave of absence for up to six months for exploratory tests and treatment related to a brain tumor.  This was followed on September 11 with an announcement that Mr. Peak would liquidate a portion of his holdings in the company to “generate liquidity for estate and tax planning purposes.”  There is no doubt that these are ominous press releases and the uncertainty associated with the situation has led to volatility and a decline in the stock price.

Before proceeding further, readers may be interested in a recent interview with Mr. Peak to get a sense of his views regarding Contango and recent market conditions.  (RSS Feed subscribers may click here for a link to the video)

Bloomberg interview with Ken Peak on June 28, 2012

A Brief History of Contango

Mr. Peak founded Contango in 1999 by investing his entire life savings of $400,000 representing an “all in bet” on the company and providing the confidence for early investors to provide seed capital to begin operations.  Between 2000 and 2007, the company raised an additional $55.5 million through five series of preferred stock which eventually converted to common stock.  Although options were used in the past to compensate employees and directors, this practice was eliminated and the company currently has no options, 15.3 million shares of common stock outstanding and a market capitalization of $785 million.

A comprehensive history of Contango is beyond the scope of this article but investors may wish to review a brief history from Contango’s perspective that was published in 2010.  It is also worthwhile to chronologically review the company description section provided in each of the company’s 10-K reports and 10-KSB reports.  Doing so will reveal important changes in the nature of the company and its operations and is not very time consuming. We also recommend reviewing Contango’s informative presentations over the years and anyone contemplating an investment should ideally read all of the presentations in chronological order to understand the evolution of the company.

Fiscal 2008:  A Pivotal Year

Although we are not presenting a comprehensive history, it is important to note that Fiscal 2008 (year ended 6/30/2008) was a pivotal year for Contango.  Prior to 2008, the company had accumulated a portfolio of properties in the Fayetteville Shale region of Arkansas.  In December 2007 and January 2008, Contango sold its interests in the Fayetteville Shale properties for $327.2 million recognizing a gain on sale of $262.3 million.  In addition, the company sold its interest in a liquefied natural gas export terminal for $68 million which represented a gain on sale of $63.4 million.

At this point in time, Contango had also participated in a significant exploration program in the shallow waters of the Gulf of Mexico (GOM).  In Fiscal 2007, the company and its partners were successful in finding oil and gas reserves which were named the Dutch and Mary Rose discoveries.  Using the proceeds of the Fayetteville property sales, Contango increased its ownership interest in the Dutch and Mary Rose properties.  The transactions were structured as a 1031 like-kind exchange for tax purposes which resulted in a large deferred tax liability (more on the significance of the deferred tax liability will be presented later).

In total, the company used $300 million of the Fayetteville proceeds to purchase these additional interests in Dutch and Mary Rose.  In a press release on February 11, 2008, Mr. Peak stated that Contango was “100% focused on the Gulf of Mexico as we continue to study our strategic options and alternatives.”  Although the company has participated in on-shore activities since 2008, the bulk of the value of Contango’s reserves and activity has been in the off-shore waters of the Gulf of Mexico ever since this pivotal shift.

For a brief period in calendar year 2007 and 2008, Contango was effectively put up for sale which is what the “strategic alternatives” in Mr. Peak’s February 11, 2008 memo refers to.  Ultimately, the sale did not work out despite very high natural gas prices and Contango’s common stock price fell dramatically both in response to the lack of a transaction and the general stock market panic in the fall of 2008.  It is clear now that a sale would have provided shareholders with a better outcome but it is less clear that failure to sell the company was an error based on information known at the time.

Contango’s Fiscal 2012 Results

Contango recently released its 10-K report for the fiscal year ended June 30, 2012 which we encourage readers to review.  The company’s revenues of $179.3 million can be attributed primarily to the Dutch and Mary Rose wells with additional contributions from the Ship Shoal 263 (Nautilus) and Vermilion 170 (Swimmy) wells.  The following table from the 10-K shows the average daily production from these wells expressed in MMcfed (millions of cubic feet equivalents per day) broken down by fiscal quarter:

For the entire 2012 fiscal year, the company produced 23,617 MMcf of natural gas, 615,000 barrels of oil and condensate, and 661,929 barrels of natural gas liquids.  Each barrel of oil and natural gas liquids has the energy equivalent of 6 Mcf, so Contango’s total production can be expressed as 31,279 MMcfe.  This represents a 3 percent decline in production from fiscal 2011.

In terms of energy content, 75.5 percent of Contango’s fiscal 2012 production came from natural gas, 11.8 percent from oil and condensate, and 12.7 percent from natural gas liquids.

During the year, the average sale price of natural gas was $3.10 per mcf, the average sale price of oil and condensate was $112.75 per barrel, and the average sale price of natural gas liquids was $55.44 per barrel.  Since the price of natural gas is so low on an energy equivalent basis compared to oil and natural gas liquids, Contango realized only 40.8 percent of its total revenues from natural gas with oil and condensate making up 38.7 percent of revenues and natural gas liquids accounting for 20.5 percent of revenues.  The company realized an average of $5.73 per mcfe, far higher than the price of natural gas, due to the much higher prices for oil and natural gas liquids on an energy equivalent basis.

The exhibit below shows the percentage of revenue and production attributable to each commodity type:

From this discussion, we can see that while Contango would have greatly benefited from higher natural gas prices, the high price of oil and condensate allowed the company to realize a price per mcfe of $5.73 for fiscal 2012 even though the price of natural gas averaged only $3.10 for the year.

In fiscal 2012, Contango had lease operating expense of $0.81/mcfe, general and administrative expenses of $0.33/mcfe, and depreciation, depletion, and amortization of $1.54/mcfe.  The total costs per mcfe was $2.68 leaving the company with a pre-tax margin of $3.05 per mcfe on its production.  On revenues of $179.3 million, the company posted $94.3 million in operating earnings and $58.4 million in net income, or $3.79 per share.

Contango’s fiscal 2012 results were respectable despite very low natural gas prices during the year due to a combination of the company’s production mix benefiting from the high price of oil and thanks to the low expense structure.  If all of Contango’s production came in the form of natural gas, it would have realized a narrow $0.42/mcfe pre-tax margin and profitability would have been far lower as a result, holding all other variables constant.  The following chart (click the chart to enlarge) was taken from a Contango presentation on January 3, 2012 and illustrates the company’s cost advantage relative to competitors:

We encourage readers to review management’s discussion and analysis in the latest 10-K for more information regarding the specific wells responsible for the year’s revenues along with additional details regarding costs and expenses.  This brief summary only serves to illustrate Contango’s favorable revenue mix in terms of natural gas vs. oil as well as to point out the cost structure advantage.  In conjunction, these two factors allow for profitability even during the current period of low natural gas prices.

Contango’s Reserves

While it is important to look at Contango’s recent operating history, it is more important to get a sense of the oil and gas reserves held by the company since this asset represents the bulk of the company’s intrinsic value.  The most “obvious” place to look for the value of the company’s reserves is the property account on the balance sheet.  As of June 30, 2012, Contango shows property, plant, and equipment of $396.3 million net of depreciation, depletion and amortization.  The vast majority of this total is attributed to the company’s oil and gas reserves.  Does it make sense to use this figure as a proxy for the value of the reserves?

The book value of an E&P company’s reserves is usually a poor indicator of the economic value of the reserves.  This is because the property account is based on the company’s historical cost of acquiring or discovering oil and gas reserves rather than an estimate of the present value of future revenues expected from the reserves.  Contango uses the “successful efforts” method of accounting which we discussed in more detail in another article.  This is a conservative method of accounting that is fairly likely to understate true economic value.

In an attempt to provide financial statement users with a more realistic estimate of the value of oil and gas reserves, the SEC requires E&P companies to calculate a “standardized measure” of reserves based on recent commodity pricing, the expected timing of production activities, and an estimate of future costs of production.  The net cash flows from the estimate is discounted at 10 percent to arrive at an after-tax figure.   The value of Contango’s reserves based on the standardized measure was $513.9 million as of June 30, 2012.  The pricing assumptions used in the calculation were:  $3.13/mcfe for natural gas;  $96.07/barrel of oil;  and $59.39/barrel of natural gas liquids.  Total proved reserves as of the date of the calculation were 256,567 MMcfe.

There is a $117.6 million difference between the company’s book value of reserves and the value based on the standardized measure.  Obviously, if natural gas prices rise from currently depressed levels, the standardized measure would also rise accordingly.  The following exhibit illustrates how volatile the standardized measure can be based on the pricing assumptions that are embedded in the calculation (click on the exhibit for an enlarged view):

Value of Deferred Tax Liability

As mentioned above, Contango has had a significant deferred tax liability on the balance sheet since entering into a like-kind 1031 exchange in which its Arkansas Fayetteville shale assets were exchanged for increased interests in the Dutch and Mary Rose discoveries.  The deferred tax liability was $118 million as of June 30, 2012. Of this amount $112 was deferred based on the 2008 like-kind exchanges.

If Contango were to sell its interests in the Dutch and Mary Rose wells that were acquired via the like-kind exchange, the company would realize a gain or a loss on sale based on the cost basis of the Fayetteville assets sold in 2008.  In a hypothetical scenario where Contango sold these interests tomorrow, the company could potentially owe the $112 million that was deferred in 2008 provided that the proceeds from the Dutch and Mary Rose sales were sufficiently high.  However, if Contango does not sell the Dutch and Mary Rose properties and eventually fully depletes the reservoirs, these properties will be plugged and abandoned rather than sold.  The value of the properties would have been recognized in depreciation and depletion expenses over the years of production and would eventually be worthless.  In this scenario, it does not appear that Contango would owe the $112 million in deferred taxes.  As a result, we prefer to heavily discount the deferred tax liability on the books to reflect its “true” likely value.

Obviously, we do not have sufficient insight into knowing if or when the tax will be due so the true value is necessarily subjective.  However, even if one assumes that the full $112 million will eventually be paid, clearly its present value is still lower than the liability on the balance sheet.

Cash and Capital Expenditures

As of June 30, 2012, Contango had nearly $130 million of cash on the balance sheet and no debt outstanding.  The company has a $146.7 million capital expenditure program planned for fiscal year 2013 ending on June 30, 2013.  These projects are expected to be funded from cash on hand and cash flow from operations.  A summary of these prospects is listed below:

In addition to the “Eagle” and “Fang” wildcat prospects in the Gulf of Mexico, Contango has budgeted to drill two additional wildcat wells in the gulf along with significant funding for the Exaro and Alta joint ventures which are land based drilling programs.  We will not go into detail here regarding the nature of these prospects other than to suggest that some will almost certainly result in “dry holes”.  That is the nature of exploration and production and is to be expected.  However, Mr. Peak seemed optimistic regarding the prospect of finding significant new reserves in a press release dated June 25, 2012.


The ultimate value of Contango is heavily dependent on the future direction of oil and natural gas prices.  As we noted previously, even in an environment of low natural gas prices, Contango is able to realize an attractive selling price per mcfe due to the company’s oil and natural gas liquid production.  Contango shareholders clearly hope that the historically low price of natural gas relative to oil is corrected by a rise in natural gas prices but there is no guarantee that the correction will not come in the form of lower oil prices.  Ultimately, investors in E&P companies have to want exposure to the underlying commodities in order to consider an investment.

Our approach for estimating Contango’s intrinsic value involves starting with the company’s stated shareholders’ equity figure of $464.3 million and making appropriate adjustments.

The first adjustment involves considering the true value of reserves versus book value of reserves due to the reasons mentioned previously.  If we decide to use the standardized measure as a proxy of value, we would need to add $117.6 million to book value.  However, recall that the standardized measure was calculated based on a very low natural gas price of $3.13/mcfe.  This price is based on an average of monthly prices during fiscal 2012 and its use in the standardized measure essentially predicts that pricing will not change for the life of Contango’s reserves.  Despite the gloomy sentiment in natural gas, the market does not agree with this assumption based on futures pricing as we can see from the following chart showing futures prices for natural gas:

In the past, Contango has provided an estimate of reserve value based on futures strip pricing (non-GAAP) but this has not been provided in the recent past.  Users of financial statements are not provided with sufficient data to plug in different assumptions to the standardized measure to obtain alternate estimates.  As a very rough proxy, however, we would point to the previous table showing Contango’s standardized measure in prior years when natural gas prices were stronger.  For example, in 2011, the standardized measure was $717.1 million albeit on somewhat higher proved reserves.

Ultimately, some discretion must be used but clearly any estimate consistent with market expectations would have to be higher than the standardized measure.  We have chosen to use a reserve valuation of $750 million which is admittedly not based on an exact calculation but appears defensible if natural gas trades in the $4-5 range over the next several years as the market expects.  As a result, we will adjust book value upward by $354 million ($750 million – $396 million) based on our estimate of true reserve value versus book value.

We also believe that it is appropriate to adjust book value based on the likelihood that the deferred tax liability of $112 million originating from the like-kind exchange will not be fully owed and that whatever amount owed will not be paid for several years.  While admittedly arbitrary, we assume that only half of the deferred tax liability is likely to be an economic liability and therefore we add $56 million to book value.

The result of our estimate is to take stated book value of $464.3 million and adjust it upward for $354 million in additional reserve value and $56 million for the lower economic value of the deferred tax liability.  This results in an intrinsic value estimate of $874.3 million, or approximately $57 per share compared to the current quote of $51.32/share.

We should note that we have assigned zero value to future discoveries in this valuation not because we doubt that there will be future discoveries but because we do not know of a good way to estimate their value.  In other words, the $57/share valuation essentially boils down to an estimate of the value of Contango’s remaining reserves assuming somewhat better natural gas pricing (but no better than reflected in futures markets) in a scenario where management decides to wind down the firm and cease new exploration.  To the extent that new exploration adds value, intrinsic value will be higher than our estimate.  Obviously, this cuts both ways and future exploration could destroy value.

Risks and Conclusion

As we mentioned previously, dark clouds are looming over Contango with Ken Peak’s medical leave and subsequent sale of 250,000 shares of stock due to tax and estate planning requirements (which was completed on September 20 based on SEC filings).  After the recent sale of stock, Mr. Peak continues to control 13.3 percent of Contango.  Mr. Peak’s importance to Contango is self evident based on the company’s track record of creating value and his value to the company cannot be replaced.  Although we obviously hope that Mr. Peak returns as CEO and runs the company for many more years, it is prudent to consider the scenario if a less favorable outcome occurs.

Mr. Peak has been replaced as CEO on a temporary basis by Brad Juneau.  Mr. Juneau is the managing member of Juneau Exploration LP which has been an exploration partner of Contango almost since the company’s inception. Contango outsources essentially all exploration functions to partners and Juneau Exploration has been the most important partner historically.

Space constraints prevent us from going into the details of the partnership here but the information is available in Contango’s latest 10-K.  Our observation is that Mr. Juneau’s long history working with Contango would be a positive factor if he ends up replacing Mr. Peak as CEO on a permanent basis.  However, the extensive list of related party transactions outlined in the latest 10-K present significant potential conflicts of interest.  These conflicts could be dealt with most cleanly if Contango purchases Juneau Exploration.  However, the terms of such a transaction, if it is even agreeable to Mr. Juneau, are obviously unknown.

Whether Mr. Juneau or another individual takes over as CEO, it is quite likely that a new CEO would have to be paid far more than Mr. Peak has been paid historically.  This could include stock options or other dilutive instruments.  Until recently, Contango has operated with a staff of under ten employees and this bare bones operation probably reflects Mr. Peak’s personality and position as a major shareholder.

If no deal can be struck with Mr. Juneau, it is also possible that the company may put itself up for sale rather than seek new leadership.  If so, the company would be sold under today’s natural gas pricing environment and our intrinsic value estimate could be too optimistic.

Despite the risks outlined here, we find the risk/reward situation compelling for several reasons.  First, Contango is one of the only E&P companies we know of that has no debt, no hedges, and no potentially dilutive securities outstanding.  In most E&P companies, an equity investor could very well lose his entire investment due to the presence of leverage.  Even an adverse outcome for Contango is not going to wipe out equity holders.  Second, Contango is trading below what we believe to be a conservative estimate of the economic value of reserves based on only a mild improvement in natural gas pricing.  Third, we have given no credit to the company for its current exploration program which is likely to add incremental value based on the company’s track record.

In summary, Contango is a potentially interesting investment and a compelling risk/reward situation with an important caveat:  The investor must want exposure to natural gas and oil and be willing to bear the consequences of severe adverse developments in commodity prices. Those who do not seek such exposure should not consider Contango or any other E&P company.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Contango Oil & Gas Company.