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Contango Oil and Gas sees its future onshore, in West Texas’s Delaware Basin

Contango is one of the few small companies with the financial strength to make the transition from offshore exploration in the Gulf of Mexico to onshore North American resource play development

Jody Chudley is is a contributor to Agora Financial’s Outstanding Investments and Real Wealth Trader.

Oct 24, 2016

by Jody Chudley

The Play

Offshore exploration in the Gulf of Mexico and onshore North American resource play development are both in the business of oil and gas production. Other than that, these two activities could hardly be more different.

There aren’t too many small producers that deal in both of them but Contango Oil & Gas is one of them. The future of the company is going to be onshore in the Delaware Basin portion of the Permian. The right acreage in this play can deliver decent returns at $45 per barrel WTI. To put that in perspective, operators in the Bakken and Eagle Ford plays aren’t terribly interested in drilling wells at prices $20 higher than that. No wonder Delaware Basin acreage still goes for $20,000-plus per acre despite depressed oil prices.

In July 2016, Contango moved to secure 5,000 net undeveloped acres in the Southern Delaware Basin. The purchase price was $25 million. At $5,000 per acre, this has the look of a great deal for Contango.

The Pick

Contango Oil & Gas (NYSE:MCF)

19-contango-offshore-acquisition-story

Contango was founded in 1999 by a sharp, charismatic CEO named Ken Peak. Like many at the time, Peak believed the U.S. was going to become desperately short of natural gas. Conventional production was in decline and new discoveries were few and far between.

He formed natural-gas-focused Contango with three core beliefs: The only competitive advantage in the commodity business is to be a low-cost producer; virtually all of the value creation that occurs in the oil and gas business is through the successful drilling of exploration wells; and the only point of the oil and gas business is to increase shareholder wealth on a per share basis.

He was smart and shareholder friendly, and was himself a major Contango shareholder. He believed the best place to find natural gas was on the Gulf of Mexico’s shelf, the relatively shallow portion of the gulf closest to the shoreline. Few companies were still actively exploring on the shelf but Peak, like many interesting businessmen, was a contrarian at heart. He also had an ace up his sleeve with access to a crack exploration team that had been responsible for several of the largest natural gas discoveries made on the shelf. Peak was able to attract this team by giving them an ownership percentage in the wells – a big upside for them with little risk.

The plan worked perfectly. Contango made several significant natural gas discoveries, natural gas prices were strong and the company’s market capitalization soared to nearly $1 billion in 2008.

Being a sharp businessman and knowing that shale gas was becoming a real risk, Peak prepared the company for sale. But before any transaction could be completed, the financial world fell apart. Lehman Brothers collapsed, financial markets froze and the opportunity to exit vanished.
The company continued on with the same business model into a lower natural gas prices. Then, in 2012, Peak was diagnosed with an inoperable brain tumour and took a medical leave of absence. In early 2013 he passed.

Faced with depressed natural gas prices, the new leadership directed the company towards onshore oil. In October 2013, Contango combined its pristine balance sheet in a merger with the overleveraged Crimson Exploration’s Eagle Ford and Woodbine shale oil assets. Both companies got what they needed, but Contango was once again thwarted by commodity markets when oil prices collapsed in 2014. Like most North American shale-oil plays, the Woodbine and Eagle Ford wells aren’t worth drilling at $45 oil.

Thus the move into the Delaware Basin. Contango is one of the few small companies with the financial strength to make such a transition.

The Postscript

Concurrent with the Delaware Basin acquisition, Contango issued five million shares at $10. With that cash, Contango has an estimated 2017 Debt to EBITDA ratio of just 1.2 times. That is amongst the best of any of Contango’s peer group. If oil and gas prices were to increase, this balance sheet would be significantly underleveraged.

The company also has lots of liquidity with $70 million drawn on a $140-million credit facility. Management has indicated it is committed to living within cash flow in 2017 so the balance sheet isn’t going to get worse.

Analysts see cash flow going from $31 million in 2016 to $60 million in 2017 and $103 million in 2018 on Delaware Basin production growth without much help from commodity prices. With an enterprise value of just over $300 million, Contango starts looking pretty inexpensive by 2018.

Jody Chudley doesn’t own shares of MCF

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