Over the past month, there have been a number of notable developments at Contango Oil & Gas Company. The company’s stock price has remained under significant pressure due to a number of company specific factors including a dry hole and concerns regarding the health of Chairman Ken Peak.

We published a bullish profile of Contango on September 22.  Since the article generated quite a bit of interest and reader comments, we will present a summary of the key developments over the past month along with potential implications for the company going forward.

Eagle Dry Hole

On October 19, Contango reported that its Ship Shoal 134 prospect (Eagle) proved to be a dry hole.  The company expects that total costs to drill, plug, and abandon the well will be approximately $29.5 million.  Since Contango uses the successful efforts method of accounting, the cost of the dry hole will appear as an exploration expense incurred during the current quarter.  Contango’s production operations are very profitable so it appears likely that the cost of the dry hole will be partially offset due to tax effects.  Assuming a 35% tax rate, the net costs of the dry hole should be approximately $19.2 million, or $1.25 per share.

Dry holes are an inevitable and unpleasant aspect of exploring for oil and gas.  However, Eagle is one of several planned exploration initiatives for the current fiscal year.  As we noted in the original profile of Contango, the company has a capital expenditure budget of $146.7 million for the current fiscal year.  The company is currently drilling its South Timbalier 75 prospect (Fang) with results expected by late November.  Fang may well turn out to be another dry hole with a similar dry hole cost to Eagle but it could also result in the addition of new reserves.  Ultimately, the skill of the exploration team will determine the success of the overall exploration program which must be judged over the course of several attempts rather than one dry hole.

Onshore Projects

Contango provided an update on its onshore activities in the same press release announcing the Eagle dry hole:

• The company has purchased approximately 336 acres in the Tuscaloosa Marine Shale from Goodrich Petroleum Company and entered into an operating agreement to become a 25% non-operating working interest partner.  $4.3 million has been invested to acquire acreage and drill the first horizontal well with Goodrich.  A total of $8.8 million has been invested so far to lease approximately 24,000 acres in the Tuscaloosa Marine Shale.  This investment is still in its early stages so we will have to wait for management to provide an update on any new reserves.
• The Alta Energy partnership in the Kaybob Duvernay located in Alberta, Canada has proceeded with four vertical test wells and the first successful horizontal well.  Alta plans to spud its second horizontal well and continue with an evaluative drilling and completion program in 2013.  Contango has invested approximately $12.3 million of its $20 million commitment to Alta so far and owns a 5% interest in the Kaybob Duvernay project.
• The Exaro Energy venture with Encana Oil & Gas in the Jonah field located in Wyoming is proceeding on schedule with three rigs drilling.  Production is currently approximately 3.3 million cubic feet equivalent per day net to Contango.  Contango has invested approximately $41.3 million of its $67.5 million commitment which should be sufficient for all planned drilling through the end of 2012.

Although most of the onshore activities are at early stages of development, it appears that the Exaro venture is resulting in proved reserves and production.  Further details will likely appear in Contango’s next 10-Q report in early November.

Proxy

Contango released its annual proxy statement on October 12.  The company scheduled its annual meeting of shareholders for November 29 in Houston and provided a number of details that are worth noting:

• Brad Juneau, the company’s acting CEO, is not directly compensated by Contango for his services although he does receive compensation as the sole manager of Juneau Exploration which shares revenue with Contango on a number of exploration prospects.  Although the “related party transactions” documenting Mr. Juneau’s economic interests raises certain conflict of interest questions, it is remarkable that Contango is not paying any direct compensation for his services.  Most companies would have to pay a significant sum to attract talent capable of properly managing the company on an “acting” basis.
• Brad Juneau currently directly owns 55,000 shares of Contango plus 30,000 additional shares held in an irrevocable trust for his children.  Mr. Juneau purchased the majority of his directly held shares recently at prices between $49.08 and $49.75 as reported in a Form 4 filing in early October.  With an economic interest of nearly $4.2 million in Contango shares, Mr. Juneau’s interests seem well aligned with Contango shareholders.  Unlike most companies that seek to align the interests of management with shareholders, Contango did not give Mr. Juneau restricted stock or options.  Instead, Mr. Juneau parted with actual cash to purchase his shares.  This appears to be a very positive sign.
• Contango has a history of transparent compensation policies with clear goals and objectives required to earn cash bonus compensation.  The company did not award any equity compensation over the past year and currently has no options outstanding.  Ken Peak earned slightly less than $2 million during Fiscal 2012, down from nearly $7 million for Fiscal 2011 due to lower bonus compensation.  We encourage readers to review the proxy statement’s compensation section.  Those who read many proxies will likely find the company’s compensation practices to be very transparent compared to most other companies.
• Although no further details were provided regarding Mr. Peak’s medical condition, the proxy statement still contains language that implies that he is actively involved as Chairman in setting compensation for other executive officers and setting overall corporate policies.  There is also language related to Mr. Peak’s fiscal 2013 salary and bonus being prorated if he returns as CEO.  While this language may just be boilerplate information, the prospect of Mr. Peak’s return is at least presented as a possibility. If the board had reason to believe that he would definitely not return, it seems reasonable to believe that such language would not have been used.
• On a less positive note, the vesting of Mr. Peak’s option grants at Contango ORE were accelerated to vest immediately.  Contango ORE is a separate publicly traded company that was spun off from Contango in late 2010.  Readers may wish to review Contango ORE’s proxy statement for further details.

Insider Purchases

In addition to Brad Juneau’s purchases discussed above, other executives at the company have been buying shares recently.  Yaroslava Makalskaya, the company’s Vice President and Controller, purchased shares on September 13, October 4, and October 5.  Sergio Castro, the company’s Chief Financial Officer, purchased shares on September 28.  Although these purchases did not involve a large number of shares, there is only one reason that insiders would be motivated to use their own cash to acquire shares.

Summary

Over the past month, Contango has reported some negative news with the announcement of a dry hole with after-tax costs to shareholders of approximately $1.25 per share.  On the other hand, recent insider buying could be perceived as bullish particularly given the size of Mr. Juneau’s purchases.  Contango’s proxy seems to hold out the hope that Mr. Peak may return at some point during this fiscal year.

The overall investment thesis discussed in our original article a month ago appears to be intact.   It is particularly noteworthy to observe that Contango’s shares now trade near a 52-week low while natural gas prices are near a 2012 high.  Time will tell whether Contango’s future exploration activities bear fruit but we remain convinced that the company represents a solid choice for investors interested in natural gas exposure without assuming the additional risk of balance sheet leverage.

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