The Rational Walk
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The Facts Change at Contango Oil & Gas May 8, 2013

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 September 22, 2012

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.

Pitfalls in Oil & Gas Accounting September 11, 2012

One of the most important task investors face involves identifying distortions in a company’s financial statements which may obscure actual economic performance or distort comparisons with other firms in the same industry. For purposes of this discussion, we are not referring to cases of financial fraud where company executives purposely seek to mislead users of financial statements.  Although cases of fraud are often well publicized, for the most part executives do attempt to work within the guidelines of generally accepted accounting principles (GAAP).  However, GAAP itself is often vague on important points and sometimes offers executives more than one fully sanctioned approach.  In this article, we take a brief look at one aspect of accounting for oil and gas exploration companies that often leads to investor confusion.

Valuation of Oil and Gas Reserves

Exploration and production (E&P) companies attempt to use their capital to find new sources of oil and gas that were previously unknown.  Companies typically use geological surveys and other data to identify promising sites and then obtain leases giving them the right to drill.  Wildcat exploration involves drilling exploratory wells that may or may not result in the discovery of economically sufficient reserves of oil and gas.  In cases where oil or gas is discovered, the company has found an asset that has to be reflected on the balance sheet.

Once the reserves have been found and accounted for as an asset on the balance sheet, production activities will begin and the company will take periodic depletion charges against the asset as resources are extracted.  This is in line with the matching principle of accounting where the revenue that is being generated is matched with the cost associated with the revenue.  Over time, the resource will be fully exploited and the asset will be worthless.  The company will have benefited from the revenues produced by the resource over time and will have fully recognized the cost of exploration required to discover the resource.  In addition, the company will expense production costs as they are incurred.

Successful Efforts vs. Full Cost Accounting

GAAP accounting requires E&P companies to choose either “successful efforts” or “full cost” accounting when it comes to tracking the value of reserves.  We are only providing a cursory overview here to make some high level points.  This is a complex topic and we refer readers interested in a more in depth treatment to read Fundamentals of Oil & Gas Accounting which provides a relatively brief overview in Chapter 2.  This is not an inexpensive book so we suggest that readers only interested in this specific topic refer to Google Books which should allow readers to review enough pages to cover most of Chapter 2.

Both successful efforts and full cost accounting are historical cost accounting methods which attempt to record an accurate valuation for reserves based on funds that the E&P company has spent on the process of securing leases and drilling exploration wells.  This means that both methods can fail to reflect reality since the value of the reserves that are found may have little relationship to the cost of finding the reserves.  Indeed, the entire point of exploration is to locate reserves that are much more valuable than the funds required to make the discovery.

The most important difference between successful efforts and full cost accounting is that a successful efforts company does not capitalize the cost of “dry holes”, or exploration wells that do not result in the discovery of new reserves.  In contrast, full cost companies will capitalize the cost of all exploration activity into a full cost “pool” regardless of the success or failure of individual exploration wells.  As a result, a full cost accounting company will typically carry reserves at a higher valuation on the balance sheet compared to a successful efforts company. The more dry holes that are drilled, the greater the potential difference between the reserve valuation recorded by a full cost company versus a successful efforts company.

The full cost company will have higher periodic depletion expenses compared to a successful efforts company since the higher valuation of the reserves will require higher levels of amortization as resources are produced.  In contrast, the successful efforts company will have “lumpy” earnings compared to a full cost company since all dry holes will be booked as an expense immediately.

Both successful efforts and full cost companies are required to take impairment charges if the book value of reserves fall below the “standardized measure” that attempts to calculate the value of reserves based on commodity pricing on the balance sheet date.  However, due to the higher reserve valuation carried by full cost accounting firms, impairments are far more likely for a full cost company especially if many dry holes have been drilled over time.

Implications for Investors

There are a number of important implications for investors evaluating a E&P company or attempting to compare multiple companies that are not all using the same accounting method.

First, investors must account for the fact that both successful efforts and full cost accounting are historical accounting methods and the book value of reserves on the balance sheet will almost never match the actual economic value of the reserves.  Particularly for companies that use successful efforts accounting and also have a good track record of avoiding dry holes, the value of reserves on the balance sheet could be far lower than the actual economic value of the reserves.

Second, investors should be aware that companies using full cost accounting are more likely to have the book value of reserves at a level closer to economic value when compared to a successful efforts company.  Since all exploration costs including dry holes are capitalized into a full cost pool, the book value of reserves will always be higher than under successful efforts accounting unless the company never drills dry holes, an outcome that is very unlikely.  Due to the higher book value of reserves, it is more likely that a full cost accounting company will face impairment charges during periods when commodity prices are very low.

Third, investors must be aware that impairment charges are never reversed when commodity prices increase.  In other words, impairments are one way streets:  Companies must write down the value of reserves if commodity prices make the reserves worth less than book value at the reporting date but can never “write up” the reserves when commodity prices rebound.  As a result, a full cost accounting company will often show relatively low depletion costs in subsequent accounting periods since the book value of the resources subject to depletion have been written down.

Which is More Conservative?

It appears clear that the successful efforts method of accounting is more conservative than full cost accounting since dry holes are immediately recognized as an expense rather than capitalized.  However, defenders of full cost accounting counter than successful efforts may suffer from showing a lower-than-realistic valuation for reserves.  Furthermore, the true cost of developing a “portfolio” of reserves should reflect both successful and unsuccessful attempts.

Management teams who we respect have made different choices.  For example, Contango Oil & Gas Company uses the successful efforts method and Loews Corporation has opted for the full cost accounting method for its HighMount subsidiary.  Ultimately, the choice between full cost and successful efforts accounting involves questions of philosophy as well as conservatism and investors are probably best served by remaining agnostic on the issue.  What is important is to understand the differences between the accounting methods particularly when comparing the book value of reserves and the depletion charges of companies using different accounting methods.

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

Natural Gas Remains Depressed With No End in Sight September 3, 2012

“If something cannot go on forever, it will stop.”

— Herbert Stein

When it comes to financial markets, there is a major difference between observing a pricing anomaly and profiting from it.  In most cases, observing inefficient pricing involves significant subjective judgment calls.  Such is the case when one declares that Facebook common stock is “obviously overvalued” or that buying an insurance company trading at two-thirds of tangible book value is “clearly too cheap”.  In both cases, subsequent events could make such pronouncements appear foolish in retrospect. Despite the best efforts of legions of computer scientists, algorithms are of limited assistance in addressing this problem although value investing principles can help reduce errors or at least provide downside protection.

In the physical world, it is easier to make definitive statements regarding observed relationships.  For example, we can say that one barrel of crude oil has approximately six times the energy content of one thousand cubic feet (mcf) of natural gas.  This is a physical relationship that has long been confirmed by scientists and is not a point of debate.  Of course, this does not mean that the price of one barrel of crude oil must equal the price of six mcf of natural gas.  In fact, a number of factors such as the superior transportability of crude oil versus natural gas have resulted in the price of a barrel of oil to average about ten times the price per mcf of natural gas.

Oil:Natural Gas Ratio Reaches Record Levels … in 2009

Nearly three years ago, we observed that the oil:natural gas ratio had reached what appeared to be rather extreme levels.  As we noted at the time, over the previous twenty-three year period, the average ratio was 10, the minimum ratio was 4.3, and the maximum ratio was 21.5.  At the time, the ratio stood near the record high levels and there was much talk about the potential for industry to substitute natural gas for other forms of energy.  The most obvious substitution effect we have seen over the past few years has been in electricity generation.  We again noted the apparent cheapness of natural gas in December 2010 and March 2011 making similar observations as the oil:natural gas ratio became more extreme.

Electric Utility Industry Shifts from Coal to Natural Gas

It is not as if market participants have been oblivious to the opportunity provided by cheap natural gas.  The electricity generation industry has clearly absorbed some of the increased supply of natural gas in recent years.  Joy Global, a leading provider of equipment for the coal mining industry, noted this trend in its recent earnings release:

As noted, U.S. coal has experienced the most severe decline, driven primarily by lower electricity demand and electricity generators switching to natural gas. Electricity demand in the U.S. was down over 5 percent during the winter heating season, which is greater than the 4 percent decline in 2009 that resulted from the global recession. On top of slowing demand, shale gas production has been expanding rapidly and creating a significant surplus of natural gas in the U.S. This has depressed natural gas prices to 10-year lows and also has increased the dispatch of gas fired generation onto the electricity grid. As a result, coal’s share of electricity generation has dropped from 43 percent to 32 percent between 2006 and April of 2012 while the natural gas share increased from 18 percent to 32 percent over the same period.  [Emphasis added]

Clearly, price signals are having a major impact at least in one very important industry.  However, this incremental demand has not resulted in any observable improvement in the price of natural gas in recent years nor has it done anything to normalize the oil:natural gas ratio.  A full discussion of the supply/demand dynamics of the industry is beyond the scope of this article but we can recommend The Economist’s recent Survey on Natural Gas for readers seeking more in-depth information.

Recent Trends

We were careful to point out in previous articles that just because the oil:natural gas ratio appeared to be extreme, one must not conclude that it will not reach new extremes.  This is precisely what has happened over the last year with the ratio spiking to 53.8 in late April 2012.  After subsequently falling to below 30, the ratio has recently resumed climbing and now stands at approximately 37.  The chart below shows the movements in the ratio since 2008:

Another way of looking at the same data is to compare the cost of a barrel of crude oil to the energy equivalent quantity of six mcf of natural gas.  The following chart clearly shows that natural gas is extremely cheap in absolute terms.  For approximately $15, one can purchase six mcf of natural gas containing the energy equivalent of a barrel of crude oil which now sells for nearly $100.  Obviously, natural gas and oil are not perfect substitutes but this type of price discrepancy should induce any industry capable of switching to at least give the idea very serious consideration.

Investment Implications

It is clear that observed anomalies in commodity pricing can persist for very long periods of time and there is no accurate way to forecast when prices will normalize.  There is no shortage of articles attempting to predict when natural gas prices will rise.  A recent Barron’s article suggests that crude oil production will need to drop in order to curtail natural gas that is obtained as a byproduct of crude production.  There are many other theories regarding the conditions needed for price normalization.

As Benjamin Graham observed, there is nothing illegal or immoral about speculation and those who wish to dabble in natural gas and oil futures can feel free to do so.  This, however, does not meet our definition of an intelligent investment. To qualify as an intelligent investment, we would have to be sure that a natural gas producer has a low cost of production, a good record of success in exploration, and a capital structure that will allow common shareholders to benefit from a normalization in prices even if that normalization takes much longer than anyone currently anticipates.

Oil and gas exploration is a risky enough business just based on the nature of the activity yet most firms seem to be eager to layer on even more risk via a leveraged capital structure.  In our view, the incremental upside generated by leveraging the capital structure of an oil and gas exploration and production company is not generally worth the downside risk.

Disclosure:  Individuals associated with The Rational Walk LLC own shares in companies engaged in natural gas exploration and production.

Revisiting Noble Corporation Investment Thesis and Importance of Sell Discipline February 1, 2011

Over the past eight months, a number of articles have appeared on The Rational Walk related to the Deepwater Horizon disaster and related investment opportunities.  Value investors know that times of stress and uncertainty create opportunities in the financial markets whether the turmoil is due to natural disasters, political unrest, or the fallout from accidents such as the Deepwater Horizon incident.

Panic and Uncertainty Leads to Opportunities

Mr. Market always sells entire industry sectors indiscriminately first and asks questions later.  The key question for investors involves judging where the true opportunities exist and avoiding value traps that carry risk of permanent loss of capital.  As things have turned out, investors would have done well to buy any of the stocks impacted by the Deepwater Horizon disaster including BP and Transocean.  In fact, many smart investors purchased BP stock in the wake of the disaster and have done very well.

Rather than attempting to judge the probability of ruinous consequences for BP and Transocean, we decided to focus attention on companies that were not directly involved in the disaster but had been punished by the  market nonetheless.  This research resulted in taking a position in Noble Corporation on June 3.  This position has now been closed for a total return of 38.5 percent compared to a return of approximately 20% for the S&P 500 ETF (SPY) during the same period (both figures include dividends).

Noble Investment Thesis Revisited

In our initial profile of Noble Corporation, the following main points were made regarding the bullish investment thesis:

1. Noble’s historical performance had been very strong over a long period of time and management accomplished the track record with a minimal amount of leverage.  Looking at Noble’s record from 2000 to 2009, we observed that margins and return on equity had dramatically accelerated as the price of oil skyrocketed during the latter part of the decade and that the company appeared to be managing through the dramatic decline in oil prices that took place in 2009 partly due to long term contracts at historically high dayrates.

2. Noble had a very strong record of free cash flow generation over the past five years and management appeared to have a solid strategy in place that balanced returning cash to shareholders and funding the company’s newbuild program.

3. From a geographic perspective, Noble was clearly exposed to the Gulf of Mexico but over 77 percent  of  revenues were attributed to other countries, with Mexico accounting for 23 percent of 2009 revenues.  We hypothesized (incorrectly as it turns out) that Mexico may be a destination for idled rigs in the U.S. Gulf of  Mexico in the event of an extended moratorium.

4. Based on an observation of the importance of deepwater exploration for the energy security of  the United States, we believed that a permanent ban in the Gulf of Mexico was unlikely and that once the Macondo well was capped, a more reflective political environment would result in relaxation of the ban.

Significant Events Since June 2010

While long term investors should avoid excessive focus on small developments that invariably emerge from time to time, it is critical to keep on top of all news  and developments particularly in cases where a volatile industry environment exists.  The following major events took place with respect to Noble Corporation since June 2010. (We focus on Noble-specific events rather than the timeline associated with the Macondo well itself or the political developments, all of which has been well covered elsewhere):

Noble acquired Frontier Drilling. We covered the announcement when it was made on June 30, 2010 and noted that the deal was funded with cash that Noble planned to raise in debt offerings.  The deal appeared to be done on attractive terms for  Noble and was possible only because of the company’s previous aversion to debt.  The company also announced a major agreement with Shell that added significant backlog and ensured the continued utilization of the acquired Frontier fleet.  The dayrates and terms appeared to be attractive.  Overall, this appeared to be a positive development, although the increase in financial leverage slightly increased the risk profile of  the company that was built into our initial investment thesis.

Noble announced solid Q2 2010 Results. Although results were negatively impacted by the fallout from the Deepwater Horizon disaster, Noble posted respectable Q2 results which we analyzed on July 20, 2010.  We noted that negative trends were emerging in the jackup fleet in terms of utilization and dayrates and that overall fleet utilization declined.  We  presented a ten quarter summary of Noble results to examine trends over a longer period of time.  While trends were somewhat negative, Noble still managed to post healthy cash flow for the first half of 2010.

Noble Q3 2010 Results Impacted But  “Worst May Have Passed”. Noble posted a sharp fall in contract drilling revenues for the third quarter despite the addition of the Frontier rigs.  We covered the quarterly release on October 21 and noted continuing drops  in fleet utilization and dayrates.  Although the results were disappointing, the Obama Administration had recently lifted the official moratorium and it appeared  that Q4 results would be materially better.  Based on our analysis of the fleet and contracted dayrates, we estimated that contract drilling revenues would rise to the  neighborhood of $630 million in Q4.

Noble Q4 Results Announced. On January 26, 2011, fourth quarter results were announced.  Although contract drilling revenues were higher that Q3 at $614.5 million, the results fell short of our $630 million estimate partly due to a major drop in utilization for the semisubmersible fleet and dayrates that remained at depressed levels, although with a slight improvement from the third quarter.  A number of jackup rigs operating in Mexico were moved to the Gulf of Mexico and warm stacked. In the conference call following the earnings release, management guided analysts to expect a capital expenditure program of approximately $2 billion for 2011.

Noble May Face Headwinds in Q1

Based on our analysis of Noble’s fleet based on the latest fleet status report, it appears nearly certain that contract drilling revenues will decline significantly in the current quarter.  Based on our estimate, contract drilling revenues could fall to the $510 to $520 million level for the quarter due to declining revenues in Mexico, West Africa, the Arabian Gulf, and Southeast Asia.  Click on this link for our analysis of the latest fleet status and revenue projections for Q1 2011.

Sell Rationale

One of the dangers facing investors involves not having a firm sell rationale in place at the time of purchase. When a security is purchased, the investor should not only describe the reason for the purchase but also consider the conditions under which the position should be liquidated.  Some may criticize this approach as deviating from the “buy and hold” school of investing and at odds with value investing in general but nothing could be further from the truth.  Value investing is about buying undervalued securities, but without a solid sell discipline, good analysis at the outset can be diluted by failing to act when an investment thesis has played out.

In the case of Noble, the investment thesis was based on the market’s severe overreaction to the Deepwater Horizon disaster and the subsequent pummeling of nearly all stocks associated with offshore oil and gas exploration.  Based on the factors discussed above, Noble appeared to be trading at a depressed valuation relative to our evaluation of its long term normalized earnings power, free cash flow generation capability, and risk profile based on financial leverage.  Our investment thesis was not based on the price of oil.

While Noble has performed as well as one could expect in light of subsequent events and made an opportunistic acquisition that could provide long term benefits, financial leverage is higher than it was at the time of purchase and it appears to be headed higher.  Given the fact that free cash flow generation in 2011 is highly unlikely to approach the company’s $2 billion capex program, more debt may be required to fully fund these initiatives.

Avoid Changing Investment Rationale To Justify a Hold

One of the main dangers investors face involves changing the investment rationale as a stock price advances.  To justify holding Noble Corporation at $38 requires a completely different investment thesis than purchasing shares at under $28.

One could come up with a solid investment thesis for Noble even at today’s price given the company’s newbuild program, healthy backlog, capable management team, and prospects for higher oil prices to support expansion of dayrates going forward.  However, this was not our investment thesis.

At the time of purchase, our price target was in the low to mid 40s; however, this target did not account for the higher leverage and the poorer than expected results over the past two quarters and prospects for higher debt going forward.  As a result, it seems more prudent to declare victory and move on to other opportunities.

Disclosure:  The author of this article sold his position in Noble Corporation on February 1, 2011.  This article is not investment advice — see our disclaimer for more information.  By using this site, you agree to our terms and conditions.