Contango Oil & Gas (MCF)

Contango Oil & Gas is a truly unique situation. MCF has no debt, $38 million in cash, is
free cash flow positive at current natural gas prices of $4 per mcf (one thousand cubic
feet), and has one of the lowest cost structures of any E&P company. Even better is that
at current prices you can buy natural gas reserves at around $1.70 per mcf with no geopolitical
risk (reserves are in the Gulf of Mexico).

Why does the stock sell at such a level with these great statistics? One reason is that no
analysts cover the company. The other major reason is that the stock has suffered from
liquidations especially from one hedge fund manager who put his entire fund in the stock
last summer, then levered up and recently had to sell.

Investors now have the chance to buy a completely un-levered company, whose balance
sheet is like Fort Knox, with one of the cheapest costs of producing natural gas at the low
valuation of $1.70 per mcf. And you would be buying it right before another massive
surge in natural gas prices. Maybe that is why the company itself put off drilling two new
wells and instead is buying back stock.

Contango Assets Are Two Very Large Fields

Contango has an interest in 66 offshore leases. The primary assets are Contango’s
interests in its Dutch and Mary Rose reserves in the Gulf of Mexico. The Company’s
independent third party engineer recently estimated that the Dutch and Mary Rose fields
have total proved reserves of 961 billion cubic feet equivalent (“Bcfe”) (364 Bcfe net to
Contango).

Contango’s Low Cost Hyper Efficient Strategy and Philosophy Are Key

Contango has two core beliefs:
1) “The only competitive advantage in the natural gas and oil business is to be
among the lowest cost producers.”
2) “Virtually all the exploration and production industry’s value creation occurs
through the drilling of successful exploratory wells.”

Contango has lived up to both maxims. They are one of the lowest cost producers of
natural gas. Their operating costs were an astonishing $0.82 per mcfe in 2008 and their
finding, developing and acquisition costs were $1.36 per mcf, leading their costs to be a
little over $2 per mcf. The company’s largest cost is actually taxes! They pay 38% in taxes and this has
historically been their highest cost. This is indeed a rare company.

How Does Contango Achieve Such a Low Cost

To start, Contango only has 7 employees. Contango’s job is quite similar to a hedge fund manager’s:
capital allocation. Contango outsources everything else. Contango formed a partnership with Juneau Exploration L.P., a private company that finds domestic natural gas and oil prospects. Under their agreement, JEX generates natural gas and oil prospects and evaluates exploration prospects generated by others. Contango and JEX share in the upfront costs. Then if a prospect is successful, Contango
will fund the development and JEX will share in the revenue. This has been an
enormously successful partnership as evidenced by the Dutch and Mary Rose fields.
For development and operation, Contango hires contractors and independent third party
operators to do the job.

This leaves Contango with the sole job of making sure that it invests in the best possible
fields. And as part of their strategy, Contango management believes just as I do;
concentrate your bets on your best risk/reward situations. Contango has done a marvelous job growing reserves from 11.4 Bcfe in 2001 to the current 364 Bcfe with only 5% share dilution and the taking on of zero debt. It’s one thing to talk the talk; it’s another to walk the walk.

The Company was almost sold last summer. In June, Contango considered selling off its two main assets, the Mary Rose and Dutch fields, and spinning-off the future prospects to do it all over again. The company opened up its data to prospective buyers, hired an investment bank and started fielding offers. The
stock hit a high of $95.16 per share in June. But the economy and the energy markets had a different idea. The sale process was terminated in September when it became clear that due to the credit crisis and
deteriorating financial conditions, the company would get nowhere near to fair value for
its crown jewels.

Financial Hurricane, Then Real Hurricane, Then Hedge Fund Hurricane

After the financial hurricane came Hurricane Ike, which caused damage and
shut or slowed production of the company’s wells. Then news started drifting out of a hedge fund in trouble. Sellers Capital  had so believed in the Contango story, that they put almost their entire fund in the stock and then used some leverage as well. When the stock started to fall, other investors started to
worry about what Sellers Capital would do. This culminated in Sellers Capital locking the fund up and preventing a forced sale of its over 15% position in Contango.

The failed sale of the company, the collapsing energy markets, the hurricane damage and
finally the flight from the stock due to fears of massive selling and essentially, the stock
has never recovered.

Sellers Capital overhang is over

Sellers Capital told its investors that if they wanted out of the fund, they could
withdraw as of April 1st. In the meantime, the firm has sold over 800,000 shares, reducing
their position to 13.2%, or 2.24 million shares. The firm announced in a filing dated March 10th, that the firm was done selling to meet redemptions. This removes a short-term pressure from the stock that has seen relentless selling pressure. And you can see the reaction from the stock the last two days.

With A Balance Sheet like Fort Knox MCF is Buying Back Lots of Stock

Outside of short term trading fluctuations, shareholders have little to fear. The company
has $38 million in cash and no debt. They also have a $50 million untapped credit line.
And the company’s all-in costs as mentioned above are a little over $2 per mcf, meaning
that they are still cash flowing nicely even in a horrific natural gas environment. After the sale fell through last September, the company initiated a $100 million buyback. And on March 3rd, they announced that they had purchased almost 1 million shares at an average price of $44.60 per share and that meant they were essentially buying their own reserves at $2.12 per mcf, or around their very low cost of finding, developing and producing natural gas.

At today’s prices, investors and the company can buy back the stock at $1.70 per mcf!
And that is precisely what the company is doing. In one filing, Sellers Capital announced
they sold 100,000 shares back to the company. Natural gas production is about to plummet
There has been a sharp decline in drilling rigs of natural gas in response to the price drop
of natural gas. U.S. drilling rigs are down 37% year to date and poised to keep falling and
Canadian natural gas rigs are down 52%. This is very important because natural gas
fields deplete much faster than oil fields. More importantly, much of the growth in natural gas has come from gas found in shale and at current prices it is not economic to drill there. Compounding this is that
production at a shale gas well will fall over 75% from Day 1 to Day 90, so you need to
constantly be drilling wells to keep production up. In the Barnett Shale formation in
North Texas, the number of operating rigs in the past four months has plummeted to 97
from 214, according to RigData. While demand is low now due to a pullback in industrial and electricity demand, investors may not realize how much natural gas production is going to fall by year end.
Consider a major natural gas producer such as Canadian Natural Resources (NYSE:
CNQ). On March 6th CNQ announced that natural gas prices would have to recover to
$6.50 to $7.50 per mcf before they ramp up production, after cutting back production
substantially in response to falling prices. Expect natural gas to surge back after the summer doldrums.

Valuation Summary

The PV-10 (standard net present valuation used for oil and gas production companies) of
this company with natural gas prices at around $6 per mcf is over $72 per share. At $9
per mcf of natural gas it is $106 per share. This shows the upside the
company has when natural gas prices recover. And prices will recover; because we need
more natural gas production, not less. In the meantime, the company has a terrific balance sheet and will be profitable and cash flow positive in even more difficult times. Any time you can buy natural gas
assets at below $2 per mcf with no geopolitical risk, you should jump at the opportunity

Aaron Edelheit is the portfolio manager of Sabre Value Fund in Santa Barbara, California.