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:

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."

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