I first introduced Fools to Contango Oil & Gas (AMEX:MCF) and its CEO, Ken Peak, back in 2007. The exploration and production company more recently weighed in as my runner-up for Best Stock for 2010. On a risk-adjusted basis, there may be no better bet in the oil patch.

Ken Peak is one of the largest shareholders of Contango, which he founded in 1999. Before that, Ken had a long career elsewhere in the oil patch, including a stint as chief financial officer of Forest Oil (NYSE:FST). He also served as an officer and cryptologist in the U.S. Navy. His various presentations have drawn on the wisdom of Warren Buffett, Alice in Wonderland, Nassim Taleb, and The Big Lebowski. I just had to get this guy in front of a Foolish audience. An email exchange resulted in the following interview.

Toby Shute: Ken, can you outline your operating philosophy at Contango, and describe how your current operations reflect that philosophy?

Ken Peak: I got a Ph.D. in the risks of too much leverage ... in my 26-year career prior to starting Contango in 1999. Three guiding principles from the lessons I've learned are: Only low-cost producers survive and prosper in a commodity business. Secondly, reserves and geophysical talent are log-normally distributed, but [Vilfredo] Pareto had it wrong. It's the rule of 95/5 not 80/20. Thirdly, "incentives drive behavior" is a fundamental principle of life, and thus everyone associated with Contango must have incentives aligned with our owners.

TS: In terms of an E&P's short-term (i.e., quarterly or annual) performance, what is the most important metric for investors to focus on? By that measure, how did Contango fare in calendar 2009, and how does that compare to the peer group?

KP: I believe even thinking about short term performance is a diversion because it takes your focus off what is really important. Our business is not quarterly or annual. One needs a 3-7 year horizon -- this is difficult, I know, because it forces shareholders to think as owners.

TS: Contango appeared alongside XTO Energy (NYSE:XTO) and Southwestern Energy (NYSE:SWN) among the decade's best performing stocks. That's one clear indicator of your long-term success. Aside from looking at a stock chart, how can an investor judge whether an E&P company has done well by its shareholders over the long haul?

KP: We live in a capitalist society -- the only point of being in business is to make a profit. We measure how successful investments are by their rate of return. I define rate of return as some profit number in the numerator divided by some investment number in the denominator.

My two favorite return measures are the eponymous "Peak Ratio," defined as shareholder earnings divided by net invested capital, and "Peak Market Cap," defined as market capitalization divided by net invested capital. I couldn't find anything that totally and truly captured how I think about investing, so I made these two up. Here are the calculations:



Contango's Ratio

Peak Ratio

(Retained earnings + Dividends) / [Equity-(Retained earnings + Dividends)]

27.3 [times]

Peak Market Cap Ratio

Market cap / [Equity-(Retained earnings + Dividends)]

55 [times]

TS: You sold your Fayetteville shale interests to XTO and Petrohawk Energy (NYSE:HK) two years ago for over $300 million. Just about everyone has since jumped on the shale bandwagon, but you've moved on. How come?

KP: The growth in natural gas shale reserves is the best thing that has happened to America in terms of energy independence in my 37-year career. The challenges with shale plays -- from Contango's perspective -- are: the large negative cumulative capital required for 3-5 years, (upfront acreage costs and dozens and dozens of wells before cumulative capital switches from being negative to being positive) in combination with 60-80% decline curves (the "Red Queen" syndrome), and the sheer manpower intensity -- hundreds of wells are required. The analogy of "manufacturing reserves" is often made to shale plays, and in truth there are some legitimate similarities, but it was never a desire of mine to be in the manufacturing business. I'll take the excitement and the disappointment of drilling high risk, high return wildcat exploration wells. In a football analogy it's like 3 yards and a cloud of dust vs. the West Coast offense -- both can be successful.

TS: Most other Gulf of Mexico players are either pushing the deepwater frontier, a la Anadarko Petroleum (NYSE:APC), or, following McMoRan Exploration's (NYSE:MMR) recent successes, drilling deep into the shelf. What is it about conventional shelf exploration that's got you hooked?

KP: I'm not hooked on anything, but I'm a contrarian by personality and instinct. I wish everyone would leave the Shelf and let Contango work it by ourselves. Besides, we're "only" drilling to 16-17,000 feet in less than 300 feet of water -- it's a whole different ball park, and capital required, than the one Anadarko & McMoRan are playing in.

TS: I know you also wanted to discuss the current interest rate environment. Who benefits here, who gets hurt, and what are you doing at Contango to make the best of this situation?

KP: Contango is currently investing $75 million in overnight T-bills and earning one (1) basis point or .0001. That means in 12 months we will have earned a whopping $7,500. We're losing money on this investment after inflation and taxes. In short, the prudent savers in our society continue to subsidize the big banks that bet too much on financial instruments they didn't understand, homeowners who lied about their net worth and thought their houses were ATMs, and our federal government, which is fiscally and monetarily dysfunctional and determined to print us into poverty. It's like the parable we learned as school children except that we've decided to punish the ants and reward the grasshoppers.

TS: Thanks Ken, and best of luck in 2010.