Today's Buy Opportunity: Contango Oil & Gas

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By today's conventional wisdom, the Gulf of Mexico disaster has made onshore oil and gas plays the place to invest. But no one makes it big in the world of business or investing by being conventional. Ken Peak, the founder, CEO, and chairman of Contango Oil & Gas (AMEX: MCF  ) , didn't turn his $400,000 nest egg into a $100 million fortune by following a well-worn playbook. Instead, Peak wrote a whole new one.

If you want to follow the herd, be my guest. Contango, my "11 O'Clock Stock," is sticking to its core operations in the shallow-water Gulf of Mexico. I'm confident that long-term owners will remain well-rewarded by hitching their wagons to this oil and gas contrarian.

Fast facts on Contango:

Market capitalization

$677 million

Cash | debt

$40 million | $0

Current daily production

103 million cubic feet equivalent

Proved reserves at June 1, 2010

300 billion cubic feet equivalent

Pre-tax PV-10 at $4.50 gas and $75 oil

$1,033.8 million

Source: CapitalIQ, a division of Standard & Poor's, and recent company press releases.
PV-10 = Present value of future net cash flows from proved reserves, discounted at 10% annually.

How not to go bankrupt in this business
Most oil and gas exploration & production (E&P) companies follow a similar game plan. Raise capital. Acquire leasehold and seismic. Run a drill campaign. Prove up reserves. Establish a reserve-based line of credit. Use the cash flow from production, plus bank borrowings, to drill more wells. Show investors impressive PowerPoint slides demonstrating growth in production, reserves, and cash flow. Raise more equity. Rinse, repeat.

Did you spot the part about spending in excess of cash flow? This is a decent business model when times are good, but countless small E&Ps invariably run into trouble when commodity prices get crushed. It happens each cycle. Even larger names like Chesapeake Energy (NYSE: CHK  ) and Denbury Resources (NYSE: DNR  ) had investors seriously spooked during the sharp downturn in 2008. Contango calls itself "allergic" to debt, and carries none on its balance sheet. The company is effectively bulletproof, regardless of the direction of commodity prices.

Avoiding interest expenses is just one way that Contango keeps its cost structure incredibly lean. The firm also employs just eight people. There are no explorationists among those slim ranks. Instead, Contango outsources its prospect generation to an elite group of freelancers. Those folks don't see dollar one unless a drill prospect proves to be a commercial find. In the case of success, the explorers receive an interest in the ensuing production.

This unique business model translates to an all-in cost to find, develop, and produce hydrocarbons that's less than half the industry average, which Credit Suisse calculated at $5.29 per mcfe for 2009. This rock-bottom cost structure, which bests even the likes of onshore ace Southwestern Energy (NYSE: SWN  ) , is Contango's second source of staying power.

How to make tons of money in this business
Contango didn't generate one of the strongest shareholder returns of the past decade by simply protecting its downside. Instead, this conservative approach to the balance sheet and the cost structure enabled the company to undertake high-impact, risky investments over the years. Many of these swings for the fences have worked out fabulously, from the company's wildcat drilling in the Gulf to its investments in LNG and shale gas.

Importantly, Contango's bets are always sized appropriately, relative to the company's available capital. The firm could issue a bunch of shares to support these endeavors, as Brigham Exploration (Nasdaq: BEXP  ) did with its Bakken program last year. As with the case of spending in excess of cash flow, this approach can pay off, but it raises the hurdle for per-share value creation. Instead, Contango has opted to maintain a low share count. Thanks to share repurchases, it actually has fewer outstanding shares today than in 2001.

The company's approach to capital allocation is somewhat akin to the "barbell" asset allocation strategy advocated by Nassim Taleb: Keep most of your assets risk-free, but direct a small portion to profit from low-probability, extreme events (or Black Swans, as they've come to be known). Ken Peak has bagged several Black Swans, and he and his partners are still on the hunt.

The road ahead
As a result of the BP (NYSE: BP  ) oil spill, permitting is getting tougher, and costs to operate are unquestionably headed higher. As the low-cost guy in the Gulf, Contango can manage these increased costs and procedural hurdles better than most.

Contango has actually hired a new drilling engineer with vast experience in the Gulf of Mexico through past employers like Transocean (NYSE: RIG  ) . He should be an invaluable asset to the company going forward. Contango has also budgeted four Gulf wildcats for the fiscal year ending June 2011.

Offshore exploration is always a roll of the dice, but Contango's corporate structure and shareholder orientation greatly stack the odds of investment success in your favor. As Ken Peak likes to say: "Past performance is no guarantee of future results -- but it is the way to bet."

Previous recommendations:

Come back to Fool.com tomorrow for another great stock pick. There's plenty more great stock advice on Fool.com, and you can find video of each day's recommendation as well! "11 O'Clock Stock" is sponsored by Motley Fool Stock Advisor. The Motley Fool will wait at least 24 hours after this publication before purchasing shares of Contango. See our FAQs on "11 O'Clock Stock" here.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitter or RSS. Chesapeake Energy is a Motley Fool Inside Value pick. The Fool owns shares of Chesapeake Energy and Denbury Resources. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (52)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 30, 2010, at 11:31 AM, shivy1 wrote:

    Free cash flow negative for 2007 and 2008. Only been positive alittle bit in 2009. Not a good sign at all.

  • Report this Comment On August 30, 2010, at 11:49 AM, XMFSmashy wrote:

    shivy1,

    You made the same comment about Ultra Petroleum, an 11 O'Clock Stock pick by my colleague Mike Olsen. Rather than try to explain why free cash flow is not an appropriate metric for evaluating an E&P company, I think I'll write an article on the subject instead. Stay tuned.

  • Report this Comment On August 30, 2010, at 11:51 AM, XMFSmashy wrote:

    Explain in this compressed space, I mean.

  • Report this Comment On August 30, 2010, at 11:54 AM, JustMee01 wrote:

    TMFSmashy,

    I look forward to that article regarding proper metrics for E&Ps.

    Have you taken a look at Cobalt (CIE)? They're a very different play than many. But, sitting on $1B in cash with a big pile of prime realestate to explore, they seem like an interesting Wilcox Deepwater play. Any opinions?

  • Report this Comment On August 30, 2010, at 12:03 PM, TrojanFan wrote:

    MMR has grabbed my attention by following a similar contrarian strategy.

    I'd be curious to hear Tobe's views on that company.

  • Report this Comment On August 30, 2010, at 12:04 PM, XMFSmashy wrote:

    Indeed I have, JustMee01. Here's what I wrote about Cobalt before the spill:

    http://www.fool.com/investing/general/2010/03/29/this-offsho...

    And here's a recent update:

    http://www.fool.com/investing/high-growth/2010/07/30/is-coba...

  • Report this Comment On August 30, 2010, at 12:10 PM, XMFSmashy wrote:

    TrojanFan,

    One big difference between McMoRan and Contango is the size of the bets taken. MMR is doing some wild stuff, geologically, and those deep shelf wells are very costly. MMR had to do a massive equity raise last year:

    http://www.fool.com/investing/small-cap/2009/06/18/mcmorans-...

    I prefer Contango's more measured bets, as liquidity is never in question.

  • Report this Comment On August 30, 2010, at 12:13 PM, shivy1 wrote:

    TMFSmashy,

    I like to find value plays and hold long-term. If its developing nice FCF that would be a plus. I understand for an E&P company the initial stages of exploration cost capital and there will be negative operating cash until the development of the project is complete. What I meant to say is that there would need to be a significant return of cash flow to cover those costs and profit. Its not like I am picking on you guys for fun. This company still looks alot better than many of the 11'O Clock picks.

  • Report this Comment On August 30, 2010, at 12:30 PM, MegaEurope wrote:

    "Did you spot the part about spending in excess of cash flow? This is a decent business model when times are good, but countless small E&Ps invariably run into trouble when commodity prices get crushed."

    "Rather than try to explain why free cash flow is not an appropriate metric for evaluating an E&P company, I think I'll write an article on the subject instead."

    Wait a second, the article was complaining about negative FCF at other small E&Ps. It is obviously a valid concern. That said MCF's FCF has been improving and they seem like a great company and a good investment opportunity.

  • Report this Comment On August 30, 2010, at 1:14 PM, XMFSmashy wrote:

    Hey MegaEurope,

    I have a bunch of points to make on the subject of FCF in E&P land and look forward to writing that article. For now, I'll say that it's not so much the negative free cash flow in any given year that bothers me with other small E&Ps, but the way that net cash consumption is built into the operating model and how it's financed. The bank borrowings pile up and crush an operator when reserve values drop alongside commodity prices. That, or the company continually dilutes existing shareholders with new equity raises. Contango has carefully avoided such a situation, and shareholders have benefited greatly.

  • Report this Comment On August 30, 2010, at 1:49 PM, MegaEurope wrote:

    I agree with that explanation Smashy, that's how I approach cash flow too.

  • Report this Comment On August 30, 2010, at 3:06 PM, XMFSinchiruna wrote:

    If it's god enough for Toby, it's good enough for me. :) I just added MCF to my CAPS portfolio, moving it from my watchlist (where I had placed it after a previous article).

    Thanks for the tip.

  • Report this Comment On August 30, 2010, at 10:02 PM, TMFRhino wrote:

    Thanks for the write up Toby, interesting stuff.

    -Eric (TMFRhino)

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