The CEO, Ken Peak, took his life savings of $400k and started the company, which was traded on the OTCBB.
One of the original strategies was to focus on oil and gas exploration as it is an area where a lot of value can be created. Exploration skill tends to follow an uneven distribution where a minority of people will account for almost all of the oil and gas discovered. (Much like the 80/20 rule, how sports superstars command most of the pay, how superstar actors make almost all the money, etc. etc.) I believe the explorationists came from Xilka Energy, which had a very good exploration track record.
When Contango started out, it couldn’t afford to drill the wells itself. Its business model hinged on generating good exploration ideas and then convincing other people that they are good ideas. Other companies would drill the well and give Contango a cut of the profits.
Over time, Contango has been selling its prospect generation business to the explorationists who run it. Remember that the explorationists can simply walk away and restart the business with their own capital. The current situation is that Juneau Exploration (“JEX”) is pretty much owned by its explorationists and acts as Contango’s partner. JEX generates ideas for Contango and Contango pays for much of the drilling costs (they don’t farm a lot out anymore as Contango is a much bigger company).
This was Contango’s other big idea when Contango first started out. Unfortunately it did not work out so well and Contango only recovered about half of its capital.
Alta Resources / Unconventional gas
Contango entered into a joint venture with Alta Resources, which did research into extracting natural gas from shale. Once they started understanding the process, they knew what types of shale/land are good for shale gas production. The joint venture bought a lot of land rights before other people really knew its value for shale gas. Ultimately the joint venture hired investment bankers to help flip all the properties to other companies.
Nowadays Ken Peak isn’t that keen on shale gas. While wells do vary in production, there isn’t a lot of exploration risk when many wells are drilled. And it doesn’t take a lot of capital to drill a lot of wells compared to drilling in the Gulf of Mexico. Ken Peak characterizes shale gas as ‘factory’ production. As the process is more understood now, there isn’t a lot of room for value creation (this is why Ken Peak notes that landowners are getting much smarter now). He is also worried about the environmental movement, as developing shale gas involves injecting fracturing fluids into the ground with the potential of contaminating groundwater aquifers. Companies do not currently have to disclose the composition of fracturing fluids(!). There may be regulations in the future and/or NIMBY protests that will lower profits for shale gas companies.
Contango’s current partnership with Alta Resources is to look at extracting shale gas from offshore reserves. This is partially a speculative bet on much higher natural gas prices in the future. With natural gas prices so low right now, a lot of onshore shale gas is not economic. There is potential opportunity as landowners may not realize the value of offshore shale rights, which seem pretty worthless right now.
Liquid natural gas imports
Back in the day, it was thought that the US would have to import natural gas to meet its energy needs. Contango made a private investment in Cheniere Energy (symbol LNG) when its stock price was extremely depressed and things look bleak for the company in getting a LNG facility fully permitted and built (a de-gasification facility can only import liquid natural gas, not export it). Cheniere actually managed to pull it off. Unfortunately, the industry started to figure out shale gas technology and the US was flooded with cheap natural gas. Contango is very fortunate is having sold its investment in time, as it looks like the US should be exporting natural gas rather than importing it. Cheniere is in the process of trying to convert its facility to export LNG (they might succeed).
Ken Peak used to be a proponent of hedging. The problem with fluctuating natural gas prices is that losing money can seriously affect the rate of return. If the company were to lose half its value, it would have to double its value just to break even. And if the company has a small chance of going to 0, then it eventually will go to 0. This is also why Ken Peak does not like leverage, as he has seen too many E&P companies go bankrupt throughout his investment banking career.
By hedging its output, Contango is able to avoid huge drawdowns in its value. It does give away some upside but over time the rate of return is arguably superior. Ken Peak is also well aware that it is dangerous to short futures (and to take short positions via swaps). If there is a hurricane, Contango may be forced to shut production. Lower production across producers will raise natural gas prices. Contango would have zero production while it is obligated to deliver natural gas, which is now at very high prices! This is why Contango bought call options to protect itself from its swap positions / natural gas shorts. The overall position is very similar to buying put options and being long volatility*.
(*On the other hand, it may not be a perfect hedge as one set of risks was traded for another. There are likely differences in delivery location, sulfur content/penalties, mix of natural gas liquids in the natural gas, etc. Buying put options outright has fewer of these risks… though there may be a spread in price between delivery locations.)
Contango currently does not hedge. And it probably will not hedge unless gas prices are much higher and volatility is cheap.
Contango’s current strategy (as I understand it)
Other than the onshare shale partnership, Contango is going to stick to its bread and butter: wildcat exploration. In the wake of the Deepwater Horizon accident, there has been significantly less drilling activity in the Gulf of Mexico because it is harder to get permits, the environmental liabilities are higher, and because gas prices have stayed stubbornly low (most companies cannot economically drill). Ken Peak is incredibly excited about the GOM as drilling costs have come down significantly and the economics for Contango are extremely attractive. It has always been able to find gas cheaply and should be able to continue to do so.
In an ideal world, he would probably sell all of Contango’s producing assets and invest it all into wildcat drilling. Contango should be able to achieve a higher rate of return on wildcat drilling than sitting on its developed assets. Presumably there are reasons why this hasn’t happened (presumably the private market for gas assets is not very good right now with stubbornly low gas prices).
Contango seems to be having a lot of delays in getting its drilling permit as they were supposed to spud one of their prospects in Sept/October and they still haven’t done so. In the meantime, they are buying back shares. Contango should be able to acquire natural gas (or oil) assets cheaper by drilling than through share repurchases. Its rate of return is being hampered by its inability to drill drill drill.
I’m pretty bullish about natural gas. The current prices are unsustainable as few sources of natural gas are economic at these levels. Also, Fukushima was a very good thing for natural gas as power generation will shift away from nuclear. China is starting to recognize its pollution problems and this should reduce its reliance on coal. This points towards natural gas as being the fuel of choice for baseload power generation.
What I’m actually doing
Trading in and out of Contango. I recently sold all my shares and am trying to buy them back at $59. Is this a great idea compared to buy and hold? Maybe not.