Contango Oil & Fuel: Deep Bench In Use (NYSEMKT:MCF)
Contango Oil & Gas (MCF) finds its elephants on Wall Street and in bankruptcy courts. So many shareholders or potential shareholders are looking for a Guyana-type discovery announced by the partnership led by Exxon Mobil (XOM) and Hess (HES). Still, Mr. Market seldom realizes when a company is “buying” an elephant for the price of a grasshopper.
The reason is that so many companies are making a lot of claims that, frankly, Mr. Market is tired of hearing it. Instead, Mr. Market has adopted the “show me the money” stance. This company has the depth of management (deep bench) and experience to call Mr. Market’s bluff and raise it by the same amount. If management can show a deal in the properties it bought, Mr. Market will likely “throw the cards in” and get the stock up to par. In short, doubts are a thing of the past.
Both the board of directors and the company management have an unusually large and broad experience for a company of this size. This minimizes the risk of small businesses.
Source: Presentation of the Contango Oil & Gas Merger Slide October 2020.
John C. Goff, Chairman, has a very long, profitable history in the oil and gas business, as does the CEO. Mr. Goff’s investment in this company is substantial as he has the interest shown above. This interest is likely enough to control the company for the time being.
The structure shown above is after the planned merger with Mid-Con Energy Partners (MCEP). Mr. Market may be skeptical of rapid growth as it comes with difficult partnerships like Mid-Con as well as bankrupt properties like White Rose. However, this management has the experience of knowing good properties and turning those bargains into profitable businesses.
Shareholders have a glimpse of what management can do with the reported progress on the White Rose property.
Source: Contango Oil & Gas Central Oklahoma November 2020 Progress Presentation.
Management emphasizes the possible reserve additions from such a step. However, Mr. Market wants more cash flow and profits. The stories about reserves complement the oil and gas cemetery with names like California Resources (CRC) and Legacy Reserves (LGCY). Both companies are now “back in action” after wiping out shareholders and impacting some debt in a bankruptcy reorganization.
As such, Mr Market is not impressed with the current advances made by management as the destruction of coronavirus demand is overshadowing that progress to cause losses. However, the imminent recovery will be both earlier and stronger than the market expects due to the cost advances shown above. That is what sets this management apart from so many pretenders on the market. It is also why this stock has a far better future than others who make this “large reserves argument”.
The problem California Resources and Legacy Reserves had was that their reserves were relatively expensive. As a result, the cash flow never came about to the satisfaction of the market and both succumbed to relatively heavy debt burdens. Even with the recurrence of bankruptcy with less debt, both are still high-cost producers. Therefore, the realization of the reserve reports showing large reserves is questionable unless commodity prices persist for several years. Being a high-cost producer is almost always a major disadvantage in a raw materials industry, which limits the future appreciation of the share price.
Justification of the merger
The merger shows that management has a laser focus on low costs.
Source: Presentation of the Contango Oil & Gas Merger Slide October 2020.
Bolt-on acquisitions almost always minimize the risk of an acquisition. The slide above clearly shows that the Oklahoma properties are essentially screwed on.
It is also important that the Wyoming real estate is in very good business condition. Neighboring Colorado has attracted some very adverse press as that state modernized its industry regulation (some of which are justified). Wyoming currently has no such intentions.
Oklahoma has an earthquake problem that appears to be under control in recent years. However, the properties toward eastern Oklahoma would be near the center of the earthquake problem. The secondary recovery is unlikely to cause the problems that other operators are having, as the secondary recovery consists of maintaining reservoir pressure while regaining the remaining reserves at economic prices.
Often times, the secondary recovery has a high upfront cost that makes the process extremely expensive. However, by buying these businesses as distressed or bankrupt businesses, the new owner can work cheaper by devaluing the initial upfront cost by the low purchase price. The new owner often buys long-lived reserves with low rates of decline while operating equipment with a similarly long life.
The bottom line is that the merger looks beneficial for Contango shareholders. The debt ratio is likely to stay below 2 despite the current hostile industry conditions. Investors can assume that the debt ratio will become even more conservative in the future. Hence, this company has room to continue growing by buying more distressed companies.
Also note that management sold around 25 million shares to keep the debt ratio conservative. This management does not intend to make the same mistake as previous managers by allowing the debt to rise to potentially challenging levels.
This is another step that is very different from unsuccessful management. Often times, management fails to rebalance (or bolster the balance sheet) because the stock is undervalued. Before you know it, the debt burden can quickly become unsustainable. This management shows no such inclination. Financial leverage will remain low, while operational leverage will offer attractive future returns.
Source: Contango Oil & Gas, 3rd quarter 2020, press release on the results
Investors may be concerned that EBITDAX is not growing as fast as the number of shares issued. The fact that EBITDAX is growing and management is running a cost process is likely to have a dilutive effect that will cause the stock price to appreciate significantly during the recovery.
The risk, of course, is that the diluting effect will not be enough to rally the stock price. Shareholders need to be aware that John Goff has successfully led projects like this on several occasions. This experience is rare for a company of this size and increases the chances of success considerably.
The conservative leverage strategy further reduces the risk of losing the invested capital. Shareholders also need to recognize that people like John Goff expect a return on their investment in excess of 10% or 20%. Generally, they expect to triple their money over at least five years to offset the investment risk.
In general, successful investors like John Goff make their money through operational leverage rather than financial leverage. So many investors believe that financial leverage is necessary for a “home run”. But so often, it’s companies that get a ton of single and double improvements that eventually hit a home run that sustains a far higher stock price or makes the company an attractive takeover candidate.
This company seems to be avoiding some very common pitfalls in the industry while making some very attractive acquisitions. Management has yet to prove to Wall Street that this will be a very attractive profitable company. However, the operational advances made so far appear to show that evidence is on the way.
Low price stocks like this tend to be volatile and the industry itself is very volatile with little visibility. Hence there will be trading opportunities. For investors who don’t mind the sharp fluctuations in industrial prices, this stock should prove to be worthwhile over the next five years. Otherwise John Goff would not have invested so much money in this company.
Conservative future risk
Much of the risk lies in the actual promise of the properties themselves. Another acquisition was announced in late November
Source: Contango Investor Presentation November 2020.
At the same time, management announced a share offer. Hence, it is very unlikely that this purchase would add any significant financial leverage. As with the deals before this, a fair amount of equity was offered along with some debt.
This offer also includes a current production. The amortization of this transaction is approximately 2.7 years. In all fairness, most of the deals announced are very good deals on paper. The risk is putting them all together and running them over a period of time.
This management has the experience to achieve this.
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Disclosure: I am / we are MCF XOM HES HESM for a long time. I wrote this article myself and it expresses my own opinion. I don’t get any compensation for this (except from Seeking Alpha). I do not have a business relationship with any company whose stocks are mentioned in this article.
Additional disclosure: Disclaimer: I am not an investment advisor and this article is not a recommendation for buying or selling stocks. Investors are encouraged to review all company documents and press releases to determine that the company meets their own investment qualifications.