E&P 101 (The Short Course)Contango is in the "upstream" sector of the U.S. energy business, as opposed to the refining and other "downstream" sectors of marketing refined products such as heating oil, gasoline, and distribution of natural gas. The exploration for oil and natural gas is a very mature business (N.B. mature does not equate to stable) that has been around for over a hundred and forty years. As a result, all of the easy to identify and obvious oil and gas fields have already been discovered. Thus, the U.S. domestic industry has had to rely on improving technology to economically find and produce increasingly geologically complex and smaller oil and gas accumulations.
E&P 101 (Continued)Contango, like other exploration and production ("E&P") companies, is in the business of creating and drilling the very best reward/ risk oil and natural gas prospects at hopefully economically attractive prices. The difficulty of actually executing and achieving this modest business plan should not be under estimated. In addition to the challenges that face virtually all companies in all industries - i.e., lots of smart, aggressive, well-capitalized competitors - E&P companies face several additional challenges as well. First, we produce a commodity (oil or natural gas) whose prices can and frequently do vary widely and sometimes wildly.
E&P 101 (Continued)Further, the core of our business involves geoscientists trying to piece together a multi-variable, 3-dimensional puzzle to determine if conditions existed over geologic time (30-100 million years) to source, trap and profitably produce oil and natural gas. Further complicating the puzzle is that only some of the variables are knowable and, oftentimes, some of the variables that you think you know, may in fact, be wrong.
3 Types of E&P CostsIn the E&P business, there are three major cost components: - Discovery costs - known as finding and development costs ("F&D")
- Extraction costs - known as lease operating expense ("LOE")- Everything else - known as general and administrative ("G&A"), interest expense and income taxes F&D costs include the costs to acquire a mineral lease (leasehold costs), costs to acquire seismic data (seismic data are reflected sound waves that image beneath the surface of the earth and are used to identify potential accumulations of oil and natural gas), costs to evaluate this data and put together a "prospect" to be drilled and the actual costs of drilling and developing an oil or natural gas field.
3 Types of E&P Costs (Contd)Also included are the costs for prospects that are generated and never drilled and "dusters" or a "dry hole" where a well was drilled, but no reserves were found. Acquisition costs of purchasing already proven and producing reserves are also included in F&D costs. A major goal for Contango will be to control F&D costs through an alliance with a premier group of explorationists - Juneau Exploration, LLC ("JEX"). This alliance shifts the up-front people costs of generating prospects and identifying acquisition opportunities to these proven prospect generators. These explorationists prefer to free lance because they believe they will make more money from overrides than they would as salaried employees. Thus, Contango is getting some of the industry's very best talent on risk-shifted favorable terms.
3 Types of E&P Costs (Contd)LOE costs are the costs incurred to extract the oil and gas from beneath the earth's surface to a central gathering or shipping point. These costs are, to a large extent, a function of the reservoir. Typically, the more energy a reservoir has to "push" the produced reserves to the well bore, the lower the LOE costs will be. Also, included in these costs, are the severance and ad valorem taxes owed to states and municipalities. A cost conscious, efficient operator can play an important role in keeping LOE costs down. All other costs include various management, accounting, insurance, legal costs, etc. involved in the day-to-day running of a company as well as interest on debt (if any) and income taxes on profits (if any). Contango will undoubtedly borrow money as it grows and thus, interest and principal payments will be incurred. Since the company's overarching goal is to be profitable, hopefully we will also be paying income taxes.
RevenuesOil and natural gas are commodities that trade off of highly visible reference prices (Nymex futures pricing, field postings, and various pipeline hubs) with adjustments for gravity, Sulfur, etc., and nearness to a pipeline in the case of crude oil; and btu content, impurities, etc., and nearness to a pipeline in the case of natural gas. Contango has no ability to increase the market price of oil or natural gas, but there are ways to improve the company's margins through diligent marketing, laying pipeline gathering systems, building gas plants and other strategies to capture a share of the "downstream" value chain.
Competitive AdvantageWhat is Contango's strategy to achieve a competitive edge? In all commodity businesses, the only real competitive advantage is to be a low-cost producer. Contango's strategy to be a low cost producer includes the following: F&D cost - shift as much as possible of the day-to-day people costs associated with generating and screening prospects through its alliance with JEX. Stay focused on the funding and drilling of a prospect, the most value added part of the value chain. Make sure the explorationists who work for us have the right stuff.
Interest Cost - keep leverage modest. Debt can allow a company to grow faster and sometimes earn a higher ROE. The trade-off, though, is a loss in financial flexibility and an inability to jump on opportunities. Also, time is not on you side when you're over-leveraged, and in a highly cyclical business, timing cycles is critical to success.
Competitive Advantage (Contd)LOE - Outsource. Contango intends to use contract operators or rely on other working interest owners for the day-to-day operations in producing its production. Contango will be charged for its proportionate share of these costs including G&A or Copas accounting charges. Thus, while there's never a "free lunch", the company is only incurring these costs when and as there is a revenue producing well to offset the costs. The other advantage is that these "variable" costs have a way of becoming "fixed" as staff grows to support operations. It is important that the company pick reliable, prudent operators, however, as there is a loss of control, to some extent, involved in outsourcing. General & Administrative - Outsource. Contango has outsourced its accounting and relies on outside lawyers and insurance brokers for legal and insurance advice. Interest expense is a function of the company's debt level, which we intend to keep modest. Income taxes are inevitable if the company achieves its ultimate goal of being profitable and an industry leader in profit margin.
CompetitionThere are two types of competition in the oil and gas business. The first is present in all industries - other companies who are competing to generate and control the same assets, or in our case, the same oil and gas leases, prospects or producing properties that we are seeking. Virtually all of these companies are significantly larger and better capitalized than Contango. Moreover, they are staffed with smart, competent individuals who are dedicated to building their companies. As formidable as these companies are, however, they are not our only or necessarily most formidable competitive challenge.
Competition (Contd)The second challenge is to avoid overpaying for leases, seismic data and producing reserves, and managing our capital and the risk profile of the wells we decide to drill. There are always lots of developing "hot plays" and "deals" available in the oil and gas industry. The scarce skill set and managements largest value added opportunity/ challenge is sorting through these "hot plays" and "deals" and avoiding the temptation to drill the inferior reward/ risk prospects. Of course, no one purposefully drills a dry hole, and identifying the wells that are going to be successful in advance of drilling is impossible because of the many variables involved and the numerous and entirely feasible interpretations of both reward (expected profit) and risk (the probability of an undesired outcome). Nonetheless, this skill set, or combination of skill, hard work, and perhaps luck is the single most important ingredient for success in the E&P business.
What Are the Risks?In the energy business, like all other investing endeavors, risk/reward go hand in hand. Our goal is to minimize risk to an irreducible uncertainty I.e., we have done all we can to reduce risk and the next step is to drill a well. Some of the more common errors made by the industry that we hope to avoid are summarized as follows:
- Gambler's Ruin - Winner's Curse - Confirmation Bias - Commodity Price Volatility - Too Much Debt
What Are the Risks? (Contd)Gambler's Ruin is also referred to as the law of large numbers. In the oil business, it means not giving yourself enough "rolls of the dice" or drilling a large enough number of wells to allow the probabilities of success to work for you. The way to avoid gambler's ruin is to be judicious in sizing the dollar commitment to each individual well and to always have excess capital available. Winner's Curse, which is sometimes referred to as buyers remorse, is what you feel after you bid for an asset - and win. Oil and gas properties/ prospects are frequently auctioned or "shopped" to a number of potential buyers. The challenge for Contango is to avoid the temptation to get in a bidding contest, overpaying and thus regretting our purchase. Since we will almost always face some competition for every asset, property or lease that we buy, staying disciplined is crucial.
What Are the Risks? (Contd)Confirmation bias is that totally human propensity to look for data that confirms one's conviction and explain away or ignore data that is disconfirming. The whole art and science of generating and selecting the right prospects to drill or acquisitions to purchase involves reviewing a multitude of variables with multiple interpretations. Accepting the fact that one of the assumptions you most want to believe may not be right is difficult. Maintenance of this type of objectivity is critical to success. Commodity price volatility is a fact of life with oil and gas. The ups are fun, but the downs are devastating for high debt, high cost companies. We intend to work very hard to keep our costs and leverage low, which should help reduce our vulnerability to price dips. We also will, from time-to-time, hedge our production including swaps, collars, selling calls/ buying puts, seek off-balance sheet financing, or enter into joint-venture arrangements with purchasers that "lock in" our commodity prices.
What Are the Risks? (Contd)Too Much Debt. High debt in a volatile, depreciating asset commodity business is a prescription for disaster. While a little debt can help avoid dilution and leverage rates of return, too much debt has meant the demise of many an independent. We are targeting to maximize debt at about 35% of the PV10 of our properties.
SummaryIn summary, we're optimistic about the opportunities we think are in front of us, despite being fully cognizant that most independent oil and natural gas exploration and production companies over the last two decades have been "value destroyers" rather than "value creators". We think a renewed industry commitment to profitability is absolutely essential. We believe Contango's sole focus on the highest value added component of the value chain, and low cost structure are key to this profitability. Finally, and perhaps the single most important investment criteria of all: Incentives Drive Behavior. Contangos management and the Board of Directors own collectively 60% of Contango's stock and are incentivized to grow asset value and earnings per share.