With Loews Corporation’s market capitalization of $17,721 million, investors are paying $1,361 million for the rest of Loews, commonly referred to as the “Loews stub”, which had tangible book value of $3,808 million as of March 31, 2013. The Loews stub includes wholly owned subsidiaries HighMount Exploration & Production LLC and Loews Hotels along with cash and investments at the holding company level.

We first wrote about the valuation of the Loews stub in early 2012 when the discount was somewhat larger than it is today.  For an updated analysis, please read the follow-up posted on BeyondProxy.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Loews Corporation.

Mr. Peak was a unique figure within the oil and gas industry and was often referred to as the “Warren Buffett of oil and gas” based on his plain spoken manner, straight forward management style, and constant attention to the creation of shareholder value.  In our limited interactions with Mr. Peak and his management team, it was clear that the company has been run in an unusually shareholder friendly manner.  Mr. Peak’s obituary in the Houston Chronicle provides further details regarding his many accomplishments.

We wrote about Contango several times over the past four years and published a bullish write-up on the company in September 2012 one month after Mr. Peak’s leave of absence began.  We encourage readers to review that write-up prior to proceeding since we will not repeat most of the financial details here.  Although Mr. Peak’s illness was obviously serious, we felt confident that the shares continued to provide good value due to the company’s oil and gas reserves, our view of the management succession plan, significant insider buying, and an extremely conservative balance sheet.  Unfortunately, several subsequent events have significantly chipped away at each of these pillars of the investment thesis.  In this article, we will take a look at the most important changes that have taken place over the past few months and assess whether the shares still represent a conservative commitment of capital.

Reserve Impairments

Over the past two quarters, a disturbing trend of reserve impairment has developed at Contango:

• As of the date of the latest 10-K on June 30, 2012, the company reported 257 Bcfe of proved reserves with a PV-10 of $730.2 million.
• For the quarter ended September 30, 2012, a relatively minor impairment of 2.2 Bcfe was recorded. This was followed by an additional impairment of 20.7 Bcfe for the quarter ended December 31, 2012 bringing the total impairment for the first half of fiscal 2013 to 22.9 Bcfe, or nearly 9 percent of the proved reserves reported to be in place as of June 30, 2012.
• The company has produced approximately 13 Bcfe over the first half of  the fiscal year leaving reported reserves at December 31, 2012 at 221 Bcfe.
• In a presentation announcing the acquisition of Crimson Exploration (more on this later), the company stated that proved reserves as of March 31, 2013 stood at 196 Bcfe and PV-10 was $572 million.  The decline from December 31, 2012 clearly signals additional impairments in the latest quarter since production rates cannot fully account for the 25 Bcfe decline.

Contango’s next 10-Q, expected to be filed later this week, should provide details on the nature of the latest impairment.  The exhibit below shows Contango’s proved reserves on an annual basis since 2000 along with proved reserves as of December 31, 2012 and March 31, 2013.  All figures are from the company’s 10-K filings except the figures for December 31, 2012 and March 31, 2013 which come from the company’s latest 10-Q and the Crimson merger presentation respectively.

One of the risks facing Contango shareholders has been that the company’s proved reserves are concentrated in its Dutch and Mary Rose field as noted in the risks section of the latest 10-K.  Unfortunately this risk has materialized during the current fiscal year:

The Company’s reserves and revenues are primarily concentrated in one field.

Approximately 89% of our proved reserves are assigned to our Dutch and Mary Rose discoveries which have ten producing well bores concentrated in one reservoir and are producing through two production platforms. Reserve assessments based on only ten well bores in one reservoir are subject to significantly greater risk of being shut-in for a variety of weather, platform and pipeline difficulties. In addition, the risk of a downward revision in our reserve estimates is also greater.

Contango has recorded impairments to proved reserves at the Dutch and Mary Rose fields in the past.  On June 10, 2010, a 48.5 Bcfe downward revision was announced by the company with Mr. Peak also announcing that he and the management team would receive no bonus payments for the fiscal year as a result.  In contrast, it is unfortunate that shareholders had to learn about the reserve impairment in the latest quarter only by being alert enough to draw inferences from a slide during a merger presentation.

Crimson Exploration Merger

On April 30, 2013, Contango announced that it would acquire Crimson Exploration in a all-stock transaction in which each share of Crimson would be converted into 0.08288 shares of Contango resulting in Crimson shareholders owning 20.3 percent of the post-merger Contango.

The value of the shares to be issued in the transaction was approximately $147 million at the time the deal was announced.  In addition, Contango will assume Crimson’s $244 million of debt.  Although Contango is clearly the larger company and the acquirer in this transaction, Crimson Exploration’s management will run the combined company once the deal closes.  We will not provide a full overview of the merger terms in this article but interested readers can access the merger presentation for a condensed overview and we also recommend reading Crimson’s latest 10-K report.

Major Strategic Shift

The Crimson acquisition represents a major strategic change for Contango.  Contango has historically been focused on oil and gas exploration in the Gulf of Mexico and has avoided unconventional shale plays with the exception of a few joint ventures that have not been material to the company’s valuation.  Crimson, in contrast, has focused on unconventional onshore oil and gas exploration.  As Mr. Peak’s many presentations over the years made clear, the economics of drilling in the Gulf of Mexico have been far more attractive over time because discoveries produce very low cost reserves.

We encourage readers to review Mr. Peak’s last presentation given just prior to his medical leave of absence last August.  In particular, slide 11 on Gulf of Mexico economics shows how the overall economics of Contango’s historical approach has added low cost profitable reserves for shareholders as evidenced by slide 4 pointing out that Contango’s recent cost per Mcfe was in the $2.68 to $2.86 range — a level that produced profits even in the depressed natural gas market that has prevailed in recent years.  In contrast, Crimson’s costs per Mcfe came in at $8.57 for the latest quarter according to a recent press release.  Leaving aside the overall economics or valuation for Crimson, it is clear that the operating models of the two companies have been quite different.

The rationale for the merger is that the combined company will have a more diversified mix of reserves with Contango’s offshore low cost reserves balanced by Crimson’s unconventional onshore reserves.  The strength of the combined balance sheet should also allow more Crimson prospects to be drilled since the limiting factor would no longer be Crimson’s highly leveraged capital structure.  Another advantage stated by both management teams is that the risk profile of exploration for the combined company will be lower since riskier offshore exploration will be balanced by onshore exploration with much higher success rates.

It should be noted that the strategy outlined in the merger presentation never seemed to appeal to Mr. Peak in the past and he often emphasized the superior economics of a Gulf centric exploration program.  Volatility in periodic results did not appear to bother him very much.

Crimson’s Management

While Contango shareholders may have been less than thrilled with the idea of issuing shares near a multi-year low in order to acquire Crimson, one can only imagine the horror of Crimson shareholders when they learned that they would be bought out at around $3.19 per share.  Crimson management has regularly made promotional presentations in which “net asset value” was calculated at many multiples of the prevailing share price.  Curiously, all of these presentations appear to have been removed from Crimson’s website which now only has the merger presentation posted under the presentations section.  However, we have obtained the latest Crimson presentation which was made on April 17, 2013, less than two weeks before the merger announcement.  Here is the relevant slide on valuation (click to enlarge):

Rather than jumping for joy as Contango shareholders at the great value we are apparently receiving, we instead cringed at the idea that our future management team would feel it appropriate to present a highly promotional estimate of “net asset value” less than two weeks before announcing a deal in which their shareholders would be compensated at a tiny fraction of this figure.  Although all of the usual warnings and caveats were presented by management and this probably covers them from a legal standpoint, the ethics of the situation is most troubling.

Crimson’s management emphasized the “premium” they were receiving for stockholders during the merger call even though shares had only recently traded above the agreed price and, apparently without any irony, affirmed that Crimson shareholders would be able to benefit from growth in the combined entity since the deal was an all-stock transaction.  Of course, the combined company would have to appreciate many-fold to even begin to make up for the low sales price relative to management’s claimed “net asset value”.

It should be noted that Crimson’s top management will come out of the transaction in good shape taking over management of the combined entity with attractive employment agreements for the CEO and CFO.  All Crimson stock options will also vest and convert to Contango options using the merger exchange ratio.  This is very generous treatment for a management team that presided over enormous destruction of shareholder capital at Crimson.

The Facts Have Changed

“When the facts change, I change my mind. What do you do, sir?”

– J.M. Keynes

Investing in oil and gas exploration companies is always an inherently risky endeavor and Contango was never an exception to this reality of the industry.  However, the company had a number of unique attributes that appeared to stack the odds in the investor’s favor.  The most important of these attributes included that fact that the company had a history of successful exploration that led to the creation of very low cost reserves in the Gulf of Mexico and had able and honest management in place with a strong shareholder orientation.  In addition, the company’s ultra conservative balance sheet made it almost unique in the industry and was attractive for those who did not wish to compound the inherent risks of oil and gas exploration with balance sheet risk associated with a heavy debt load.

Unfortunately, most of the underlying pillars upon which our investment thesis was based have been weakened over the past several months.  While Mr. Peak’s leave of absence and death was clearly a major negative from the perspective of shareholders, the trend of reserve impairments and the Crimson merger represent even larger warnings signs.  Contango’s reserves are concentrated in one field that now has a history of reserve impairment and could face additional impairments in the quarters and years to come.  The company has now had two CEOs since Mr. Peak took a medical leave and while we were comfortable with both CEOs and the rest of the management team, we are completely uncomfortable with Crimson’s team which will take over after the merger is complete for the reasons mentioned previously.

But Isn’t Contango “Stealing” Crimson a Positive Development?

Contango may very well be “stealing” Crimson based on the acquisition price if the proved reserves and reserve potential advertised by Crimson turns out to be accurate and if Contango’s balance sheet can reduce debt service costs and allow for additional drilling of the most promising Crimson prospects.  The combined company will have 311 Bcfe of reserves and a PV-10 of $932 million based on the merger disclosures.  Pro-forma enterprise value is roughly $900 million and debt as a percentage of total capital should be around 24 percent which is still quite conservative.  In addition, the combined company will have about $100 million in tax losses that can be used to offset future taxable income.  A case can certainly be made that the risk/reward scenario is compelling for continuing shareholders.

Never Back Into a Position

The bottom line is that we consider the combined Contango/Crimson entity under the management of Crimson to be a fundamentally different entity than the pre-merger Contango sharing few of its financial qualities and even less of its management philosophy.  Therefore the company must be evaluated as if it were a candidate for a new investment.  The alternative is to “back in” to the position by default which is always inadvisable.

Warren Buffett has on many occasions advised investors to not own a stock for ten minutes if they would not be willing to own it for ten years.  With Mr. Peak running the show, Contango clearly passed the test.  This did not guarantee results but shareholders were reasonably well assured that the results of their investment would roughly match the change in the company’s intrinsic value over long periods of time.  This is manifestly not the case with Crimson’s management team.  We are quite sure that Crimson’s management will, in ten years time, be materially richer than they are today.  We are equally uncertain about the fate of continuing Contango shareholders and therefore prefer to look elsewhere for investment opportunities.

Disclosure: No position in Contango Oil & Gas or Crimson Exploration

– Charlie Munger, BBC Interview, October 2009

One of the most common mental errors facing investors is the tendency to anchor on various round numbers.  This tendency has been in the spotlight today with the Dow Jones Industrial Average nearing the 14,000 level.  Putting aside the fact that the industrial average is a highly flawed benchmark, does it make any sense to attach meaning to a specific nominal level of a market index over long periods of time?

Rather than focusing on the valuation of the industrial average, it seems more interesting to examine Berkshire Hathaway because the stock is also approaching a “round number” of $150,000 per class A share.  Berkshire’s record high closing price was on December 10, 2007 at $149,200 per share and its intra-day high was on December 11, 2007 at $151,650.  Only fifteen months later, the stock closed at $72,400 on March 9, 2009, a decline of over 52 percent from its record high.  The stock has advanced 104 percent since the nadir to a recent $148,000.  In this article, we take a look at Berkshire’s valuation in December 2007 and compare it to the company’s valuation today in an effort to determine whether investors should be anchoring on the magic $150,000 level.

Book Value Growth since 2007

As Warren Buffett has stated on many occasions, growth in Berkshire’s book value per share can serve as a useful proxy for growth of intrinsic value over time even though book value significantly understates the intrinsic value of the business.  Mr. Buffett elaborated on this point in his 2011 letter to shareholders:

We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values. That’s because the amount by which Berkshire’s intrinsic value exceeds book value does not swing wildly from year to year, though it increases in most years. Over time, the divergence will likely become ever more substantial in absolute terms, remaining reasonably steady, however, on a percentage basis as both the numerator and denominator of the business value/book-value equation increase.

If the correlation between book value and intrinsic value provides clues regarding Berkshire’s valuation, it makes sense to examine how Berkshire’s book value has progressed over the past five years.  The exhibit below shows book value per A share from September 30, 2007 to September 30, 2012 which is the last date for which financials have been made available:

Growth of 7.6 percent per year is normally not something to get very excited about.  However, taking into account Berkshire’s size and the fact that this growth was delivered during a period encompassing the worst economic downturn since the Great Depression, this seems like a respectable overall performance.  Book value was more than 44 percent higher on September 30, 2012 compared to its level five years earlier.

Berkshire’s Price-to-Book Ratio

A very simple metric for gauging Berkshire’s valuation is the price-to-book value ratio.  This ratio simply compares Berkshire’s trading price at any given time to book value per share.  Since there is a lag between the end of each quarter and the time when shareholders are able to review financials, we are still working with September 30, 2012 book value even though it is almost certain that December 31, 2012 book value is higher.  The exhibit below shows Berkshire’s price-to-book value ratio from January 1, 2007 to February 1, 2013:

It is obvious that Berkshire’s price-to-book ratio has fluctuated dramatically over the past six years.  At the start of 2007, the ratio hovered around 1.5 which is near the average ratio for Berkshire since the turn of the century.  However, by December 2007, the ratio rose dramatically to 1.93 which coincided with the stock’s record high.  After falling back to its historical average over the first nine months of 2008, the ratio became extremely volatile rising back to 1.93 very briefly in September 2008 and then plummeting to 1.0 exactly two months later in November 2008.  Of course, this was the period of maximum uncertainty in the fall of 2008 when it was not clear whether the financial system would survive.

One can examine the subsequent years in more detail, but the general point of the chart is to show that Berkshire’s price-to-book ratio has never risen back to its historical average of 1.5.  Although the stock has more than doubled from its low point in March 2009, the price-to-book ratio has never exceeded 1.5 and has approached 1.0 on a number of occasions.  When Berkshire began trading close to 1.0 times book value on a sustained basis in Q3 2011, Warren Buffett decided to authorize a buyback of shares at prices up to 1.1x book value.  The buyback limit was subsequently raised to 1.2x book value in December 2012.

Conclusion

We have not attempted to present a comprehensive valuation of Berkshire Hathaway in this brief article. However, a complete valuation of the company is not needed to emphasize the point that a nominal level of $150,000 per share for Berkshire is meaningless without considering the context in which the stock price reaches that level.  The change in Berkshire’s book value per share is a crude but approximate way of gauging changes in intrinsic business value over time.  The 44 percent growth in book value per share over the past five years clearly shows that we are dealing with a very different valuation scenario at $150,000 in February 2013 versus December 2007.

Statements like “Berkshire has not been this expensive in over five years” are meaningless and misleading if put in any context related to the company’s valuation.  If one wishes to crudely approximate the price at which Berkshire would have to trade at today to be as “expensive” as it was in December 2007, it makes more sense to look at the price-to-book ratio from December 2007 and apply it to Berkshire’s last reported book value figure.  Using that approach, Berkshire would have to trade above $215,000 per share today to be as expensive as it was in December 2007 based on price-to-book value.  Of course, this is not to suggest that Berkshire’s intrinsic value is anywhere close to $215,000 today.

A crude approximation of intrinsic value could involve applying Berkshire’s historical price-to-book ratio of 1.5 to September 30, 2012 book value and arriving at $168,000 per share.  Based on the 1.5x ratio, Berkshire’s shares in December 2007 were only worth about $116,000 per share rather than $150,000 per share.  However, the reader is cautioned to treat price-to-book ratios as only crude benchmarks.  Additional approaches to valuation can be found in The Rational Walk’s 2011 report on Berkshire Hathaway.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Unfortunately, the reality is not quite so simple.  The fact that a market may be statistically cheap is not, by itself, a sufficient condition to realize market beating returns over time.  Investors involved in the Japanese market in recent years can attest to this harsh reality.  However, it is very likely that significant opportunities exist in Japan despite the many macroeconomic and corporate governance concerns cited as the usual reasons for statistical cheapness.  How should investors go about identifying promising companies in Japan while avoiding value traps?

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We published a bullish profile of Contango on September 22.  Since the article generated quite a bit of interest and reader comments, we will present a summary of the key developments over the past month along with potential implications for the company going forward.

Eagle Dry Hole

On October 19, Contango reported that its Ship Shoal 134 prospect (Eagle) proved to be a dry hole.  The company expects that total costs to drill, plug, and abandon the well will be approximately $29.5 million.  Since Contango uses the successful efforts method of accounting, the cost of the dry hole will appear as an exploration expense incurred during the current quarter.  Contango’s production operations are very profitable so it appears likely that the cost of the dry hole will be partially offset due to tax effects.  Assuming a 35% tax rate, the net costs of the dry hole should be approximately $19.2 million, or $1.25 per share.

Dry holes are an inevitable and unpleasant aspect of exploring for oil and gas.  However, Eagle is one of several planned exploration initiatives for the current fiscal year.  As we noted in the original profile of Contango, the company has a capital expenditure budget of $146.7 million for the current fiscal year.  The company is currently drilling its South Timbalier 75 prospect (Fang) with results expected by late November.  Fang may well turn out to be another dry hole with a similar dry hole cost to Eagle but it could also result in the addition of new reserves.  Ultimately, the skill of the exploration team will determine the success of the overall exploration program which must be judged over the course of several attempts rather than one dry hole.

Onshore Projects

Contango provided an update on its onshore activities in the same press release announcing the Eagle dry hole:

• The company has purchased approximately 336 acres in the Tuscaloosa Marine Shale from Goodrich Petroleum Company and entered into an operating agreement to become a 25% non-operating working interest partner.  $4.3 million has been invested to acquire acreage and drill the first horizontal well with Goodrich.  A total of $8.8 million has been invested so far to lease approximately 24,000 acres in the Tuscaloosa Marine Shale.  This investment is still in its early stages so we will have to wait for management to provide an update on any new reserves.
• The Alta Energy partnership in the Kaybob Duvernay located in Alberta, Canada has proceeded with four vertical test wells and the first successful horizontal well.  Alta plans to spud its second horizontal well and continue with an evaluative drilling and completion program in 2013.  Contango has invested approximately $12.3 million of its $20 million commitment to Alta so far and owns a 5% interest in the Kaybob Duvernay project.
• The Exaro Energy venture with Encana Oil & Gas in the Jonah field located in Wyoming is proceeding on schedule with three rigs drilling.  Production is currently approximately 3.3 million cubic feet equivalent per day net to Contango.  Contango has invested approximately $41.3 million of its $67.5 million commitment which should be sufficient for all planned drilling through the end of 2012.

Although most of the onshore activities are at early stages of development, it appears that the Exaro venture is resulting in proved reserves and production.  Further details will likely appear in Contango’s next 10-Q report in early November.

Proxy

Contango released its annual proxy statement on October 12.  The company scheduled its annual meeting of shareholders for November 29 in Houston and provided a number of details that are worth noting:

• Brad Juneau, the company’s acting CEO, is not directly compensated by Contango for his services although he does receive compensation as the sole manager of Juneau Exploration which shares revenue with Contango on a number of exploration prospects.  Although the “related party transactions” documenting Mr. Juneau’s economic interests raises certain conflict of interest questions, it is remarkable that Contango is not paying any direct compensation for his services.  Most companies would have to pay a significant sum to attract talent capable of properly managing the company on an “acting” basis.
• Brad Juneau currently directly owns 55,000 shares of Contango plus 30,000 additional shares held in an irrevocable trust for his children.  Mr. Juneau purchased the majority of his directly held shares recently at prices between $49.08 and $49.75 as reported in a Form 4 filing in early October.  With an economic interest of nearly $4.2 million in Contango shares, Mr. Juneau’s interests seem well aligned with Contango shareholders.  Unlike most companies that seek to align the interests of management with shareholders, Contango did not give Mr. Juneau restricted stock or options.  Instead, Mr. Juneau parted with actual cash to purchase his shares.  This appears to be a very positive sign.
• Contango has a history of transparent compensation policies with clear goals and objectives required to earn cash bonus compensation.  The company did not award any equity compensation over the past year and currently has no options outstanding.  Ken Peak earned slightly less than $2 million during Fiscal 2012, down from nearly $7 million for Fiscal 2011 due to lower bonus compensation.  We encourage readers to review the proxy statement’s compensation section.  Those who read many proxies will likely find the company’s compensation practices to be very transparent compared to most other companies.
• Although no further details were provided regarding Mr. Peak’s medical condition, the proxy statement still contains language that implies that he is actively involved as Chairman in setting compensation for other executive officers and setting overall corporate policies.  There is also language related to Mr. Peak’s fiscal 2013 salary and bonus being prorated if he returns as CEO.  While this language may just be boilerplate information, the prospect of Mr. Peak’s return is at least presented as a possibility. If the board had reason to believe that he would definitely not return, it seems reasonable to believe that such language would not have been used.
• On a less positive note, the vesting of Mr. Peak’s option grants at Contango ORE were accelerated to vest immediately.  Contango ORE is a separate publicly traded company that was spun off from Contango in late 2010.  Readers may wish to review Contango ORE’s proxy statement for further details.

Insider Purchases

In addition to Brad Juneau’s purchases discussed above, other executives at the company have been buying shares recently.  Yaroslava Makalskaya, the company’s Vice President and Controller, purchased shares on September 13, October 4, and October 5.  Sergio Castro, the company’s Chief Financial Officer, purchased shares on September 28.  Although these purchases did not involve a large number of shares, there is only one reason that insiders would be motivated to use their own cash to acquire shares.

Summary

Over the past month, Contango has reported some negative news with the announcement of a dry hole with after-tax costs to shareholders of approximately $1.25 per share.  On the other hand, recent insider buying could be perceived as bullish particularly given the size of Mr. Juneau’s purchases.  Contango’s proxy seems to hold out the hope that Mr. Peak may return at some point during this fiscal year.

The overall investment thesis discussed in our original article a month ago appears to be intact.   It is particularly noteworthy to observe that Contango’s shares now trade near a 52-week low while natural gas prices are near a 2012 high.  Time will tell whether Contango’s future exploration activities bear fruit but we remain convinced that the company represents a solid choice for investors interested in natural gas exposure without assuming the additional risk of balance sheet leverage.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Contango Oil & Gas Company and Contango ORE.

Investors will soon have the opportunity to learn from and meet Charles de Vaulx at European Investing Summit 2012, the largest fully online investment conference.

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Exclusive Interview Excerpts

The following never-before released excerpts are from an exclusive interview with Charles de Vaulx.  The interview, conducted by The Manual of Ideas and Value Conferences, highlights many important aspects of Mr. de Vaulx’s “eclectic” investment style.  To hear more from Charles de Vaulx and other great investors, secure your spot at European Investing Summit 2012 today at a 40% special discount that expires on Friday, September 28.

Q: You describe your investing approach as cautious and opportunistic. How is that reflected in security selection and overall portfolio construction?

A: Well, I think I’ll try to answer your question in a sense of how that cautious and optimistic approach is reflected today, as we speak, in the overall portfolio construction of our funds and the way we pick stocks.

I think that our portfolio today is truly eclectic and multi-cap. Of course, if you look at the top ten holdings you’ll find mid-cap or larger cap stocks.  But if you look at our holdings in Asia, where statistically today the small cap stocks are much cheaper than the large cap stocks, you will find a wide array of stocks. We also hold some mega-cap stocks: Total [TOT], I don’t know if Berkshire Hathaway [BRK] qualifies as one (probably) as well as tiny, little stocks in Japan, Korea or Switzerland. We own a billboard advertising company in Switzerland called Affichage [Swiss: AFFN], and it’s quite small.

You also see our cautious and opportunistic approach reflected in the fact that we own some bonds. In the IVA Worldwide Fund here in the U.S., we have a little less than 9% in high-yield corporate bonds, mostly a residual from a lot of bonds we were buying late ’08-’09. So, as a result, many of these bonds will be maturing shortly in the next year or two or three or four. So it’s short-duration, high-yield corporates. The yield is not huge. Today, we’re talking about 4%, but these are what we deem extremely safe instruments and because the duration is short, there’s no interest rate risk there.

You also will notice the eclectic nature by the fact that we have some sovereign debt, and it’s approximately 5.1% of the portfolio. It’s mostly short-dated government debt from Singapore. The coupons, the yields, are de minimis. Here the attempt on our part is to hopefully get an equity-type return out of the underlying currency. The hope is that the Singapore dollar will keep appreciating over time and, of course, in two years from now when those bonds mature the idea is to just roll them over and buy new similar short-dated bonds and to remain exposed to the Singapore dollar. Because that country doesn’t have much of a fiscal deficit, there’s not much of a long-dated government bond market to begin with.

You’ll see the eclectic nature by the fact that we hold some gold in the portfolio, both bullion and gold-mining shares. I am happy to have convinced Jean-Marie Eveillard in late 2001 that gold-mining shares were so obscenely expensive, overpriced, that if we wanted exposure to gold we had to modify our prospectus to give ourselves the right to hold gold bullion. It’s been a great move!  We own a few gold mining shares, but it’s really de minimis and only in our U.S. registered mutual funds.  Our preference remains, by far, towards holding gold bullion.

You’ll notice that at the end of June [2012] we had 12.4% in cash. In some ways you may want to view those short-dated, Singapore dollar bonds as quasi cash in Singapore dollars. The fact that we’re not fully invested tells you that we are worried that we think that, by and large, stocks are not dirt cheap enough to be fully invested.

If you look at the kinds of names we own in stocks or at least if you look at the top-ten holdings, you’ll notice that the balance sheets of the companies we own are very strong. We are very fond of the expression Marty Whitman coined a while back, which is that it’s not enough for a stock to be cheap, it also has to be safe – “safe and cheap”.  Safety starts with the balance sheet.

The cautiousness of the portfolio is expressed by the fact that we are making some negative bets. We have virtually no financials except for a few insurance brokers, except for – and we may talk about it later – some tiny positions in Goldman Sachs [GS], UBS [UBS]. Financials in the U.S. are slightly too expensive and in Europe we think that most banks remain grossly undercapitalized.

Another negative bet you’ll notice is that, other than a few stocks in South Korea, we have virtually no exposure to emerging markets.  We have no direct exposure to the BRICs – Brazil, Russia, India and China – because even though these stocks have come down a lot last year and some of them this year, we believe that these stocks are dead. We are cautious and worried about what’s going on in China. We believe that a soft landing is in the cards, and hopefully that will not become a hard landing.  Any sharp slowdown in China will have major consequences for commodity prices, which in turn will hurt many emerging countries.

Some specific countries like India have obvious issues with inflation and current account deficits, not to mention problems with their electricity. We’ve seen in Brazil over the past year-and-a-half how government intervention has had the ability to hurt investors. Investors in Petrobras [Sao Paolo: PETR] have seen President Rousseff, basically ask the company to think more about what’s good for Brazil Inc. as opposed to doing what’s right for the company’s shareholders.

Also, we worry about what’s going on in Europe. We’re not sure what the outcome will be. It’s a big unknown and the way we express our skepticism towards what’s happening in Europe is by being 65% hedged on the euro.  We are willing to hold quite a few European stocks because we believe that many of them are multinational and not necessarily that Euro-centric.

Conversely, let’s not forget that quite a few American companies have a lot of their revenues in Europe.  Also, even in the instances when some of our European stocks are quite Euro-centric in terms of where their business is conducted, we think that some of these businesses may not be as cyclical as others, or if they are, the price of the stock may already reflect that it’s going to be a difficult economic environment for a long time in Europe. So, in other words, there are many stocks in Europe where we think the bleakness of what’s going on has already been priced in.

Q: You state that you seek investments in companies of any size that typically have one or more of the following characteristics – financial strength, temporarily depressed earnings, or entrenched franchises. What are some examples of these temporary challenges, temporary depressed earnings for otherwise financially strong and entrenched businesses?

A: I’ll give you an example from the past and a more recent example. I remember in the late ‘90s we bought McDonald’s [MCD], the fast food company. Why? Because we were impressed by how global they were, much more global than some of their competitors. We also, early on, understood what Bill Ackman saw a few years later, which is the real estate angle, the fact that they own so much real estate, a lot of it they rent out to franchisees.  Addressing your question of temporary challenges, the reason why that stock became so cheap back then is that the company was suffering because the food had become very bad — much worse than the competitors. And the service — there were many complaints about the quality of the service.

We felt that those two issues were fixable. Once those issues were recognized by top management, they were eventually able to fix them and the stock over time has gone up extensively. A more recent example would be was last summer, News Corp. [NWSA], Murdoch’s media company. They had the scandal associated with their tabloids in the UK. The stock came down and, yet, we were comfortable building a decent-sized position. The company had a very strong balance sheet, so we thought that they could suffer having to pay some fines.  With hindsight, the balance sheet was so strong that, in fact, the company has been very aggressive buying back their own shares since then. On a sum of the parts basis, a year ago, the stock fell as low as $15 or $16. We had, on a sum of the parts basis, a value of around $30.

News Corp. is a very different company than it was 20 years ago. News Corp. almost went bankrupt in the early ‘90s and at the time it was mostly newspapers, magazines, but today’s businesses, BSkyB, Fox, there’s very little print, in the sense of being threatened by the Internet. These are very powerful businesses— one of the businesses is 20th Century Fox, which is a decent business, so pretty un-cyclical businesses with no major immediate sort of threat to their businesses – high margin businesses, a very strong balance sheet.

The way we interpreted the scandal is, we thought it had a silver lining because via some super-voting structure, Murdoch controls the company. We thought that the scandal – because it’s such a public business– he would be forced to improve corporate governance, which I think he has. We felt the Chief Executive Officer, Mr. Carey, was very competent as was the predecessor, Mr. Chernin. We realized that the super-voting control allowed him to make some mistakes in the past, but small mistakes.

He lost a lot of money when he overpaid for Dow Jones, the publisher of The Wall Street Journal. He overpaid for MySpace, but in the grand scheme of things these were small deals and, conversely, to his credit as a media guy, he saw the changes that were happening in the newspaper industry and moved away from that over the years. Today, the stock is at over $24. I think that was a good example of what we thought was a temporary challenge and one that was limited to just one part of their empire.

One stock that we’ve bought over the past six, nine months is a French-based company called Teleperformance [Paris: RCF]. They run corporate call centers, and that’s a case where all of the earnings pretty much come from the United States. They’re very powerful in the U.S. In fact, for all practical purposes, the company should be headquartered and listed here. It’s sort of an accident that it is listed in France. The French founder happens to live in Miami, and it’s an interesting case where the French operations are losing a lot of money.

It’s much harder in France than in the U.S. to fire people and so they are not able to stop the bleeding right away in France, and I think we feel that we can quantify what those losses will be. Worst case, the company can hopefully shut down the business over time, and I think those losses in France mask the quality of their earnings in the U.S. Historically, there have been many instances where we have dabbled a lot in what we call high quality, yet, cyclical businesses.

If you think about temporary staffing companies – Randstad, Manpower; if you think about the freight forwarding companies –  Kuehne + Nagel, Panalpina, Expeditors International… If you think about the advertising companies, billboard advertising, they are good businesses in the Warren Buffett sense of return on invested capital — service businesses, high returns on capital, high free cash flow. They are cyclical because, oftentimes, other investors have a shorter-term horizon than we do. Whenever the economy goes south, in the world or in the country, these stocks go down, sometimes excessively so, so that the stocks implicitly forget that there’s a prospect that it’s just a cyclical downturn, not a secular change in the business. So we’ve often been doing some of this in the past.

Q: When it comes to Europe, most of your investments there are in companies headquartered in France and Switzerland. Why not more in Germany or peripheral European countries?

A: Again, great question. Let me start with Germany. In the past, we have had quite a few investments in Germany. We used to own in the early 2000s, late 1990s-2000s, Buderus [formerly Frankfurt: BUD]. It was our largest holding. Buderus is a boiler manufacturer. We’ve owned shares such as Vossloh [XETRA: VOS], Axel Springer [XETRA: SPR], Hornbach [XETRA: HBH3], the DIY retailer and so forth, but the reality is that most companies in Germany are not listed. If you think about industry, industrial companies in Germany, they are not listed because they belong to what the Germans call the mittelstand. The mittelstand are those thousands and thousands of basically small and mid-size companies, many of which are family-owned, and these companies are not listed. All those great German industrial companies basically are not available in the stock market.

Now, among the companies in the stock market, many have been recognized as good companies and so the stocks are no longer cheap — if you think about some of the auto manufacturers like Volkswagen. So for the time being, we don’t have much in Germany, although we did buy, a month ago, a large industrial German company.

Switzerland is an interesting country where there are many quality companies. Even though we’re value-oriented, we start our process with trying to identify not so much cheap-looking stocks, but quality businesses. We like quality and then we hope and pray that somehow, one way or the other, we can get it for cheap.

Switzerland has so many great businesses, whether it’s Kuehne & Nagel [Swiss: KNIN], which is an even better freight forwarding company than Expeditors International here in America. Nestle is a wonderful food company, better in my mind than Kraft [KFT]. Geberit [Swiss: GEBN] makes great plumbing products. Lindt & Sprüngli [Swiss: LISN], as I’m sure you know, makes delicious chocolates, and so it’s our bias to its quality that oftentimes has led us to Switzerland. Adecco [Swiss: ADEN] is a leading temporary staffing company, has much higher margins than Manpower [MAN], has higher margins than Randstad [Amsterdam: RAND]. They just have top-notch companies in Switzerland, and sometimes we are lucky to get them cheaply.

France is an interesting country because even though France has had and today has those socialist tendencies, France has an amazing number of great businesses, which oftentimes are global leaders. Think of Pernod-Ricard [Paris: RI]. Pernod-Ricard started as a little family-controlled business in the south of France and through astute management and acquisitions they have become a leader in the sale of liquor competing very well against Diageo, which is best-in-class in that industry. Think about L’Oreal — what a wonderful, global consumer company.  And of course everyone knows that France is the home of stocks such as LVMH and Hermes, the luxury good companies.

In France, we own Sodexo [Paris: SW] a food catering company. They compete against Compass [London: CPG] in the UK. Sodexo is a very well-run, global company. They have a huge subsidiary here in America, Marriott Services, which they acquired a long time ago.

There’s a stock we don’t own now but we’ve owned in the past. It’s become somewhat of a darling, Essilor [Paris: EI]. They are, by far, the leading company worldwide that manufacturers lenses for glasses. We’ve owned in the past Bureau Veritas. It’s a little bit like ISS [Group] in Switzerland. It’s an inspection service company and they have big market shares in many specific niches. It’s a service business, non-capital intensive. France has companies such as Legrand [Paris: LR]. Legrand is the leader worldwide in electrical switches.

France does have those global companies that are very good at what they do and, at the same time, many of these companies are family-controlled. We at IVA believe that more often than not family-controlled businesses do better than other types of business and could not agree more with Tom Russo from Gardner Russo & Gardner on that topic.  One of his big themes is that he loves, for the same reason we do, family-controlled companies because they have a long term vision and often times do great things.

The final point I want to make about France, and it’s important from a protection of minority shareholders standpoint, is that France is a pretty good place to be a minority shareholder. When there are takeovers in places like Germany or Switzerland, not to mention Italy, you often, as a minority shareholder, can be abused.

In France, especially now, compared to 20 years ago, minority shareholders are well treated when there are squeeze-outs and takeovers. The protection of minority shareholders is pretty high in France. That’s important because it just so happens that quite a few of our companies, not by design, get taken over, and when that happens we want to be well protected.

If you look at places like Italy, there aren’t that many listed companies, sort of the same reason as Germany. All these companies, like industrial companies based in northern Italy, most of them are family-owned and not listed. So there’s not that much available in the stock market, and some of the other countries in Europe — Spain, Portugal, Austria — oftentimes the biggest stocks are just the big banks and insurance companies. Most of them are, especially on the banking side, grossly undercapitalized. They may look cheap, but they are certainly not safe. Again, not a lot of quality stocks are available in the Greek stock market, or the Portuguese or Spanish one.

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Disclosure:  The Rational Walk receives a referral fee for European Investing Summit 2012 registrations originating from this site. 

Benjamin Graham

In 1984, Warren Buffett gave a presentation at Columbia University to commemorate the 50th anniversary of Security Analysis.  In The Superinvestors of Graham-and-Doddsville, Mr. Buffett made the case that the intellectual foundation provided by Benjamin Graham represents the common thread behind the incredible long term performance of a group of investors who operated in very different ways.  The investors varied greatly in terms of the type of investments made, degree of diversification used, and methods of finding ideas but they all shared in common an approach grounded in value investing principles.

Following the moves of famous investors has become a common source of idea generation for today’s investors.  Although many investors attempt to mechanically “coattail” the moves of various hedge fund managers based on quarterly SEC filings, it is more productive to attempt to identify those investors with strong long term track records and to learn from their investment philosophy.

Ronald W. Chan’s latest book, The Value Investors:  Lessons from the World’s Top Fund Managers, is an excellent compilation of interviews with twelve highly successful value investors from very different backgrounds.  Mr. Chan’s previous book, Behind the Berkshire Hathaway Curtain, which we reviewed in 2010, demonstrated his mastery of the art of the interview.  Each of the chapters in The Value Investors includes a brief section with biographical information regarding the manager along with his long term track record relative to an appropriate benchmark.  The managers interviewed are:

• Walter Schloss, Walter & Edwin Schloss Associates
• Irving Kahn, Kahn Brothers Group
• Thomas Kahn, Kahn Brothers Group
• William Browne, Tweedy, Browne Company
• Jean-Marie Eveillard, First Eagle Funds
• Francisco García Paramés, Bestinver Asset Management
• Anthony Nutt, Jupiter Asset Management
• Mark Mobius, Templeton Emerging Markets Group
• Teng Ngiek Lian, Target Asset Management
• Shuhei Abe, SPARX Group
• V-Nee Yeh, Value Partners Group
• Cheah Cheng Hye, Value Partners Group

One of the notable aspects of the list chosen for the book is the fact that these investors not only have varying methods of identifying investment ideas but also come from different cultures and operate in different parts of the world.  The important commonality is the fact that each of the investors has adopted Benjamin Graham’s principles as the foundation of their investment approach.  This does not mean that each of the investors uses the same formulas or approach.  They each have adapted the Graham principles and combined them with their own backgrounds, circle of competence, and temperament to come up with an approach that works.

It is also striking how several of the investors have incorporated views of the macroeconomy in their investment thinking while others have not.  There are few topics as controversial as whether a value investor should pay attention to macroeconomic factors as part of the investment process.  The question is not whether one should buy or sell stocks simply because of fears of recession, inflation, or turmoil in Europe.  The issue is more related to whether broad expected trends should play a role in the types of sectors and companies one researches at any given time.  Obviously, it is preferable to have macroeconomic tailwinds working in one’s favor rather than always battling headwinds.  However, it is less clear whether most investors have the ability to accurately identify headwinds and tailwinds in advance.  Reading some of the views provided in the book can help to cast light on this topic.

Walter Schloss

Perhaps the most important interview in the book is presented in the first chapter.  Walter Schloss was interviewed for the book a few months before he passed away on February 19, 2012 and the views he provides reflect the wisdom gained over a long and successful life.  Mr. Schloss, who had been managing money for decades by 1984, was also one of the investors Warren Buffett discussed in The Superinvestors of Graham-and-Doddsville.

Walter Schloss continued to outperform the market until his retirement in 2002 posting a cumulative return of 16 percent annualized (21 percent before fees) versus an annualized return of 10 percent for the S&P 500 over the course of his career.  A $10,000 investment made in 1956 would have compounded to nearly $11 million by 2002.

Mr. Schloss managed to compound money at astonishing rates for decades by studying the Value Line Investment Survey and investing broadly in a portfolio that often included over one hundred stocks.  This approach is quite different from the other investors profiled in the book many of whom advocate speaking to management and running more concentrated portfolios.  For more insights directly from Mr. Schloss, we highly recommend viewing a lengthy interview recorded by the Ben Graham Centre for Value Investing in February 2008.

Intelligent investors should attempt to learn vicariously through the experience of those who have succeeded in the field.  We highly recommend Mr. Chan’s latest book which makes this process enjoyable and informative.

Disclosure:  The Rational Walk received a review copy of the book from the author. 

Contango’s Vermilion 170

Oil and gas wildcat exploration has never been for the faint of heart.  Modern exploration techniques require significant capital investments and the regulatory climate has become more of a burden over the years.  Even with advanced technology, projects are often more likely to fail than to succeed yet the lure of mineral riches is enough to attract significant capital to the industry.  The long period of depressed natural gas prices has led many value investors to consider exploration and production (E&P) companies but often significant balance sheet risk exists which can reduce or eliminate downside protection.

In too many cases, taking a position in a E&P company is more of a speculation than an investment due to leverage, hedges requiring derivatives that are difficult to evaluate, and the prospect of significant dilution due to the use of stock options.  In this article, we look at a unique E&P company that is conservatively run, free of leverage, hedges, and stock options, and offers investors a compelling value proposition at the current quote.

A Remarkable Success Story

Contango Oil & Gas Company is an independent natural gas and oil company focused on exploration, development, and production of resources primarily in shallow waters of the Gulf of Mexico.  The company was founded in 1999 by Chairman Kenneth Peak and has compiled an remarkable track record over the past thirteen years.

Mr. Peak has been referred to as the “Warren Buffett of natural gas” and for good reason:  With $79 million of invested capital, he has built a company with a recent market capitalization of $785 million and has returned over $115 million to shareholders through repurchases.

In mid-August, Contango announced that Mr. Peak would take a medical leave of absence for up to six months for exploratory tests and treatment related to a brain tumor.  This was followed on September 11 with an announcement that Mr. Peak would liquidate a portion of his holdings in the company to “generate liquidity for estate and tax planning purposes.”  There is no doubt that these are ominous press releases and the uncertainty associated with the situation has led to volatility and a decline in the stock price.

Before proceeding further, readers may be interested in a recent interview with Mr. Peak to get a sense of his views regarding Contango and recent market conditions.  (RSS Feed subscribers may click here for a link to the video)

Bloomberg interview with Ken Peak on June 28, 2012

A Brief History of Contango

Mr. Peak founded Contango in 1999 by investing his entire life savings of $400,000 representing an “all in bet” on the company and providing the confidence for early investors to provide seed capital to begin operations.  Between 2000 and 2007, the company raised an additional $55.5 million through five series of preferred stock which eventually converted to common stock.  Although options were used in the past to compensate employees and directors, this practice was eliminated and the company currently has no options, 15.3 million shares of common stock outstanding and a market capitalization of $785 million.

A comprehensive history of Contango is beyond the scope of this article but investors may wish to review a brief history from Contango’s perspective that was published in 2010.  It is also worthwhile to chronologically review the company description section provided in each of the company’s 10-K reports and 10-KSB reports.  Doing so will reveal important changes in the nature of the company and its operations and is not very time consuming. We also recommend reviewing Contango’s informative presentations over the years and anyone contemplating an investment should ideally read all of the presentations in chronological order to understand the evolution of the company.

Fiscal 2008:  A Pivotal Year

Although we are not presenting a comprehensive history, it is important to note that Fiscal 2008 (year ended 6/30/2008) was a pivotal year for Contango.  Prior to 2008, the company had accumulated a portfolio of properties in the Fayetteville Shale region of Arkansas.  In December 2007 and January 2008, Contango sold its interests in the Fayetteville Shale properties for $327.2 million recognizing a gain on sale of $262.3 million.  In addition, the company sold its interest in a liquefied natural gas export terminal for $68 million which represented a gain on sale of $63.4 million.

At this point in time, Contango had also participated in a significant exploration program in the shallow waters of the Gulf of Mexico (GOM).  In Fiscal 2007, the company and its partners were successful in finding oil and gas reserves which were named the Dutch and Mary Rose discoveries.  Using the proceeds of the Fayetteville property sales, Contango increased its ownership interest in the Dutch and Mary Rose properties.  The transactions were structured as a 1031 like-kind exchange for tax purposes which resulted in a large deferred tax liability (more on the significance of the deferred tax liability will be presented later).

In total, the company used $300 million of the Fayetteville proceeds to purchase these additional interests in Dutch and Mary Rose.  In a press release on February 11, 2008, Mr. Peak stated that Contango was “100% focused on the Gulf of Mexico as we continue to study our strategic options and alternatives.”  Although the company has participated in on-shore activities since 2008, the bulk of the value of Contango’s reserves and activity has been in the off-shore waters of the Gulf of Mexico ever since this pivotal shift.

For a brief period in calendar year 2007 and 2008, Contango was effectively put up for sale which is what the “strategic alternatives” in Mr. Peak’s February 11, 2008 memo refers to.  Ultimately, the sale did not work out despite very high natural gas prices and Contango’s common stock price fell dramatically both in response to the lack of a transaction and the general stock market panic in the fall of 2008.  It is clear now that a sale would have provided shareholders with a better outcome but it is less clear that failure to sell the company was an error based on information known at the time.

Contango’s Fiscal 2012 Results

Contango recently released its 10-K report for the fiscal year ended June 30, 2012 which we encourage readers to review.  The company’s revenues of $179.3 million can be attributed primarily to the Dutch and Mary Rose wells with additional contributions from the Ship Shoal 263 (Nautilus) and Vermilion 170 (Swimmy) wells.  The following table from the 10-K shows the average daily production from these wells expressed in MMcfed (millions of cubic feet equivalents per day) broken down by fiscal quarter:

For the entire 2012 fiscal year, the company produced 23,617 MMcf of natural gas, 615,000 barrels of oil and condensate, and 661,929 barrels of natural gas liquids.  Each barrel of oil and natural gas liquids has the energy equivalent of 6 Mcf, so Contango’s total production can be expressed as 31,279 MMcfe.  This represents a 3 percent decline in production from fiscal 2011.

In terms of energy content, 75.5 percent of Contango’s fiscal 2012 production came from natural gas, 11.8 percent from oil and condensate, and 12.7 percent from natural gas liquids.

During the year, the average sale price of natural gas was $3.10 per mcf, the average sale price of oil and condensate was $112.75 per barrel, and the average sale price of natural gas liquids was $55.44 per barrel.  Since the price of natural gas is so low on an energy equivalent basis compared to oil and natural gas liquids, Contango realized only 40.8 percent of its total revenues from natural gas with oil and condensate making up 38.7 percent of revenues and natural gas liquids accounting for 20.5 percent of revenues.  The company realized an average of $5.73 per mcfe, far higher than the price of natural gas, due to the much higher prices for oil and natural gas liquids on an energy equivalent basis.

The exhibit below shows the percentage of revenue and production attributable to each commodity type:

From this discussion, we can see that while Contango would have greatly benefited from higher natural gas prices, the high price of oil and condensate allowed the company to realize a price per mcfe of $5.73 for fiscal 2012 even though the price of natural gas averaged only $3.10 for the year.

In fiscal 2012, Contango had lease operating expense of $0.81/mcfe, general and administrative expenses of $0.33/mcfe, and depreciation, depletion, and amortization of $1.54/mcfe.  The total costs per mcfe was $2.68 leaving the company with a pre-tax margin of $3.05 per mcfe on its production.  On revenues of $179.3 million, the company posted $94.3 million in operating earnings and $58.4 million in net income, or $3.79 per share.

Contango’s fiscal 2012 results were respectable despite very low natural gas prices during the year due to a combination of the company’s production mix benefiting from the high price of oil and thanks to the low expense structure.  If all of Contango’s production came in the form of natural gas, it would have realized a narrow $0.42/mcfe pre-tax margin and profitability would have been far lower as a result, holding all other variables constant.  The following chart (click the chart to enlarge) was taken from a Contango presentation on January 3, 2012 and illustrates the company’s cost advantage relative to competitors:

We encourage readers to review management’s discussion and analysis in the latest 10-K for more information regarding the specific wells responsible for the year’s revenues along with additional details regarding costs and expenses.  This brief summary only serves to illustrate Contango’s favorable revenue mix in terms of natural gas vs. oil as well as to point out the cost structure advantage.  In conjunction, these two factors allow for profitability even during the current period of low natural gas prices.

Contango’s Reserves

While it is important to look at Contango’s recent operating history, it is more important to get a sense of the oil and gas reserves held by the company since this asset represents the bulk of the company’s intrinsic value.  The most “obvious” place to look for the value of the company’s reserves is the property account on the balance sheet.  As of June 30, 2012, Contango shows property, plant, and equipment of $396.3 million net of depreciation, depletion and amortization.  The vast majority of this total is attributed to the company’s oil and gas reserves.  Does it make sense to use this figure as a proxy for the value of the reserves?

The book value of an E&P company’s reserves is usually a poor indicator of the economic value of the reserves.  This is because the property account is based on the company’s historical cost of acquiring or discovering oil and gas reserves rather than an estimate of the present value of future revenues expected from the reserves.  Contango uses the “successful efforts” method of accounting which we discussed in more detail in another article.  This is a conservative method of accounting that is fairly likely to understate true economic value.

In an attempt to provide financial statement users with a more realistic estimate of the value of oil and gas reserves, the SEC requires E&P companies to calculate a “standardized measure” of reserves based on recent commodity pricing, the expected timing of production activities, and an estimate of future costs of production.  The net cash flows from the estimate is discounted at 10 percent to arrive at an after-tax figure.   The value of Contango’s reserves based on the standardized measure was $513.9 million as of June 30, 2012.  The pricing assumptions used in the calculation were:  $3.13/mcfe for natural gas;  $96.07/barrel of oil;  and $59.39/barrel of natural gas liquids.  Total proved reserves as of the date of the calculation were 256,567 MMcfe.

There is a $117.6 million difference between the company’s book value of reserves and the value based on the standardized measure.  Obviously, if natural gas prices rise from currently depressed levels, the standardized measure would also rise accordingly.  The following exhibit illustrates how volatile the standardized measure can be based on the pricing assumptions that are embedded in the calculation (click on the exhibit for an enlarged view):

Value of Deferred Tax Liability

As mentioned above, Contango has had a significant deferred tax liability on the balance sheet since entering into a like-kind 1031 exchange in which its Arkansas Fayetteville shale assets were exchanged for increased interests in the Dutch and Mary Rose discoveries.  The deferred tax liability was $118 million as of June 30, 2012. Of this amount $112 was deferred based on the 2008 like-kind exchanges.

If Contango were to sell its interests in the Dutch and Mary Rose wells that were acquired via the like-kind exchange, the company would realize a gain or a loss on sale based on the cost basis of the Fayetteville assets sold in 2008.  In a hypothetical scenario where Contango sold these interests tomorrow, the company could potentially owe the $112 million that was deferred in 2008 provided that the proceeds from the Dutch and Mary Rose sales were sufficiently high.  However, if Contango does not sell the Dutch and Mary Rose properties and eventually fully depletes the reservoirs, these properties will be plugged and abandoned rather than sold.  The value of the properties would have been recognized in depreciation and depletion expenses over the years of production and would eventually be worthless.  In this scenario, it does not appear that Contango would owe the $112 million in deferred taxes.  As a result, we prefer to heavily discount the deferred tax liability on the books to reflect its “true” likely value.

Obviously, we do not have sufficient insight into knowing if or when the tax will be due so the true value is necessarily subjective.  However, even if one assumes that the full $112 million will eventually be paid, clearly its present value is still lower than the liability on the balance sheet.

Cash and Capital Expenditures

As of June 30, 2012, Contango had nearly $130 million of cash on the balance sheet and no debt outstanding.  The company has a $146.7 million capital expenditure program planned for fiscal year 2013 ending on June 30, 2013.  These projects are expected to be funded from cash on hand and cash flow from operations.  A summary of these prospects is listed below:

In addition to the “Eagle” and “Fang” wildcat prospects in the Gulf of Mexico, Contango has budgeted to drill two additional wildcat wells in the gulf along with significant funding for the Exaro and Alta joint ventures which are land based drilling programs.  We will not go into detail here regarding the nature of these prospects other than to suggest that some will almost certainly result in “dry holes”.  That is the nature of exploration and production and is to be expected.  However, Mr. Peak seemed optimistic regarding the prospect of finding significant new reserves in a press release dated June 25, 2012.

Valuation

The ultimate value of Contango is heavily dependent on the future direction of oil and natural gas prices.  As we noted previously, even in an environment of low natural gas prices, Contango is able to realize an attractive selling price per mcfe due to the company’s oil and natural gas liquid production.  Contango shareholders clearly hope that the historically low price of natural gas relative to oil is corrected by a rise in natural gas prices but there is no guarantee that the correction will not come in the form of lower oil prices.  Ultimately, investors in E&P companies have to want exposure to the underlying commodities in order to consider an investment.

Our approach for estimating Contango’s intrinsic value involves starting with the company’s stated shareholders’ equity figure of $464.3 million and making appropriate adjustments.

The first adjustment involves considering the true value of reserves versus book value of reserves due to the reasons mentioned previously.  If we decide to use the standardized measure as a proxy of value, we would need to add $117.6 million to book value.  However, recall that the standardized measure was calculated based on a very low natural gas price of $3.13/mcfe.  This price is based on an average of monthly prices during fiscal 2012 and its use in the standardized measure essentially predicts that pricing will not change for the life of Contango’s reserves.  Despite the gloomy sentiment in natural gas, the market does not agree with this assumption based on futures pricing as we can see from the following chart showing futures prices for natural gas:

In the past, Contango has provided an estimate of reserve value based on futures strip pricing (non-GAAP) but this has not been provided in the recent past.  Users of financial statements are not provided with sufficient data to plug in different assumptions to the standardized measure to obtain alternate estimates.  As a very rough proxy, however, we would point to the previous table showing Contango’s standardized measure in prior years when natural gas prices were stronger.  For example, in 2011, the standardized measure was $717.1 million albeit on somewhat higher proved reserves.

Ultimately, some discretion must be used but clearly any estimate consistent with market expectations would have to be higher than the standardized measure.  We have chosen to use a reserve valuation of $750 million which is admittedly not based on an exact calculation but appears defensible if natural gas trades in the $4-5 range over the next several years as the market expects.  As a result, we will adjust book value upward by $354 million ($750 million – $396 million) based on our estimate of true reserve value versus book value.

We also believe that it is appropriate to adjust book value based on the likelihood that the deferred tax liability of $112 million originating from the like-kind exchange will not be fully owed and that whatever amount owed will not be paid for several years.  While admittedly arbitrary, we assume that only half of the deferred tax liability is likely to be an economic liability and therefore we add $56 million to book value.

The result of our estimate is to take stated book value of $464.3 million and adjust it upward for $354 million in additional reserve value and $56 million for the lower economic value of the deferred tax liability.  This results in an intrinsic value estimate of $874.3 million, or approximately $57 per share compared to the current quote of $51.32/share.

We should note that we have assigned zero value to future discoveries in this valuation not because we doubt that there will be future discoveries but because we do not know of a good way to estimate their value.  In other words, the $57/share valuation essentially boils down to an estimate of the value of Contango’s remaining reserves assuming somewhat better natural gas pricing (but no better than reflected in futures markets) in a scenario where management decides to wind down the firm and cease new exploration.  To the extent that new exploration adds value, intrinsic value will be higher than our estimate.  Obviously, this cuts both ways and future exploration could destroy value.

Risks and Conclusion

As we mentioned previously, dark clouds are looming over Contango with Ken Peak’s medical leave and subsequent sale of 250,000 shares of stock due to tax and estate planning requirements (which was completed on September 20 based on SEC filings).  After the recent sale of stock, Mr. Peak continues to control 13.3 percent of Contango.  Mr. Peak’s importance to Contango is self evident based on the company’s track record of creating value and his value to the company cannot be replaced.  Although we obviously hope that Mr. Peak returns as CEO and runs the company for many more years, it is prudent to consider the scenario if a less favorable outcome occurs.

Mr. Peak has been replaced as CEO on a temporary basis by Brad Juneau.  Mr. Juneau is the managing member of Juneau Exploration LP which has been an exploration partner of Contango almost since the company’s inception. Contango outsources essentially all exploration functions to partners and Juneau Exploration has been the most important partner historically.

Space constraints prevent us from going into the details of the partnership here but the information is available in Contango’s latest 10-K.  Our observation is that Mr. Juneau’s long history working with Contango would be a positive factor if he ends up replacing Mr. Peak as CEO on a permanent basis.  However, the extensive list of related party transactions outlined in the latest 10-K present significant potential conflicts of interest.  These conflicts could be dealt with most cleanly if Contango purchases Juneau Exploration.  However, the terms of such a transaction, if it is even agreeable to Mr. Juneau, are obviously unknown.

Whether Mr. Juneau or another individual takes over as CEO, it is quite likely that a new CEO would have to be paid far more than Mr. Peak has been paid historically.  This could include stock options or other dilutive instruments.  Until recently, Contango has operated with a staff of under ten employees and this bare bones operation probably reflects Mr. Peak’s personality and position as a major shareholder.

If no deal can be struck with Mr. Juneau, it is also possible that the company may put itself up for sale rather than seek new leadership.  If so, the company would be sold under today’s natural gas pricing environment and our intrinsic value estimate could be too optimistic.

Despite the risks outlined here, we find the risk/reward situation compelling for several reasons.  First, Contango is one of the only E&P companies we know of that has no debt, no hedges, and no potentially dilutive securities outstanding.  In most E&P companies, an equity investor could very well lose his entire investment due to the presence of leverage.  Even an adverse outcome for Contango is not going to wipe out equity holders.  Second, Contango is trading below what we believe to be a conservative estimate of the economic value of reserves based on only a mild improvement in natural gas pricing.  Third, we have given no credit to the company for its current exploration program which is likely to add incremental value based on the company’s track record.

In summary, Contango is a potentially interesting investment and a compelling risk/reward situation with an important caveat:  The investor must want exposure to natural gas and oil and be willing to bear the consequences of severe adverse developments in commodity prices. Those who do not seek such exposure should not consider Contango or any other E&P company.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Contango Oil & Gas Company.

The Manual of Ideas recently interviewed Mr. Marks and has provided a 27-page transcript of the discussion.  Readers interested in more information can view the 50 minute video and obtain the full transcript as one of 11 great bonuses immediately upon registering for the fully online European Investing Summit 2012.

Here are a few excerpts from the interview:

“The interesting thing about investing is what I call the perversity. The point is that it is so not intuitive. It is so not obvious — investing. A great example lies in the fact that, people think that to be a good investor, you have to understand companies. But the market has an understanding of companies, and if you understand the company the same as the market does, even if the market and you are right, you are not going to make any special profits.”

“…when my son comes to me, who is a budding hedge fund investor, he gives me an idea, a stock, macro trend, or something like that, the first question I always ask is the same: Who doesn’t know that? That is really the question. When you think you know something, the question is whether the market knows it too. And if it does, then your idea has no relative superiority.”

“…[investing] is really not a good business for people who don’t have some ego because you have to do the things that Dave Swensen describes as lonely and uncomfortable. I think it was [Jean-Marie] Eveillard who said it was warmer in the crowd, in the herd. But if you only hold popular positions, you can’t do better than average, by definition. And I think you will be very wrong at the extremes.”

“The greatest example is this: If you went to the horse races, would you always bet on the favorite? The favorite, assuming the crowd is intelligent, which usually it is, is the horse with the highest probability of winning. That doesn’t mean that the favorite is always the best bet. You might have another horse that has a lower probability of winning but the odds are so much higher, that’s the smart bet…”

“[U.S. Treasuries] are a safe investment in the sense that the outcome is known and not really subject to variation. I think they are not a good investment because the known outcome is an unattractive one.  Today you can buy the ten-year [Treasury] and with no risk, lock up the certainty of 1.9% return for ten years. Is that really a good thing to lock up?”

“What the investor has to do is weigh out on the one hand price and on the other hand reality. Everybody thinks very dire thoughts about Europe and the Euro, and I would be the last person in the world to argue against that position. Then the next question is, European assets are lower in price because of the macro conditions, but are the macro conditions being viewed too pessimistically?”

“Tenet number three of our investment philosophy says we are active in less efficient markets only. We probably wouldn’t do a hedge fund for large-cap New York Stock Exchange firms because the tendencies are that those would be more efficient than others. But emerging markets, yes. Japan, yes.”

Disclosure:  The Rational Walk receives a referral fee for European Investing Summit 2012 registrations originating from this site. 

Valuation of Oil and Gas Reserves

Exploration and production (E&P) companies attempt to use their capital to find new sources of oil and gas that were previously unknown.  Companies typically use geological surveys and other data to identify promising sites and then obtain leases giving them the right to drill.  Wildcat exploration involves drilling exploratory wells that may or may not result in the discovery of economically sufficient reserves of oil and gas.  In cases where oil or gas is discovered, the company has found an asset that has to be reflected on the balance sheet.

Once the reserves have been found and accounted for as an asset on the balance sheet, production activities will begin and the company will take periodic depletion charges against the asset as resources are extracted.  This is in line with the matching principle of accounting where the revenue that is being generated is matched with the cost associated with the revenue.  Over time, the resource will be fully exploited and the asset will be worthless.  The company will have benefited from the revenues produced by the resource over time and will have fully recognized the cost of exploration required to discover the resource.  In addition, the company will expense production costs as they are incurred.

Successful Efforts vs. Full Cost Accounting

GAAP accounting requires E&P companies to choose either “successful efforts” or “full cost” accounting when it comes to tracking the value of reserves.  We are only providing a cursory overview here to make some high level points.  This is a complex topic and we refer readers interested in a more in depth treatment to read Fundamentals of Oil & Gas Accounting which provides a relatively brief overview in Chapter 2.  This is not an inexpensive book so we suggest that readers only interested in this specific topic refer to Google Books which should allow readers to review enough pages to cover most of Chapter 2.

Both successful efforts and full cost accounting are historical cost accounting methods which attempt to record an accurate valuation for reserves based on funds that the E&P company has spent on the process of securing leases and drilling exploration wells.  This means that both methods can fail to reflect reality since the value of the reserves that are found may have little relationship to the cost of finding the reserves.  Indeed, the entire point of exploration is to locate reserves that are much more valuable than the funds required to make the discovery.

The most important difference between successful efforts and full cost accounting is that a successful efforts company does not capitalize the cost of “dry holes”, or exploration wells that do not result in the discovery of new reserves.  In contrast, full cost companies will capitalize the cost of all exploration activity into a full cost “pool” regardless of the success or failure of individual exploration wells.  As a result, a full cost accounting company will typically carry reserves at a higher valuation on the balance sheet compared to a successful efforts company. The more dry holes that are drilled, the greater the potential difference between the reserve valuation recorded by a full cost company versus a successful efforts company.

The full cost company will have higher periodic depletion expenses compared to a successful efforts company since the higher valuation of the reserves will require higher levels of amortization as resources are produced.  In contrast, the successful efforts company will have “lumpy” earnings compared to a full cost company since all dry holes will be booked as an expense immediately.

Both successful efforts and full cost companies are required to take impairment charges if the book value of reserves fall below the “standardized measure” that attempts to calculate the value of reserves based on commodity pricing on the balance sheet date.  However, due to the higher reserve valuation carried by full cost accounting firms, impairments are far more likely for a full cost company especially if many dry holes have been drilled over time.

Implications for Investors

There are a number of important implications for investors evaluating a E&P company or attempting to compare multiple companies that are not all using the same accounting method.

First, investors must account for the fact that both successful efforts and full cost accounting are historical accounting methods and the book value of reserves on the balance sheet will almost never match the actual economic value of the reserves.  Particularly for companies that use successful efforts accounting and also have a good track record of avoiding dry holes, the value of reserves on the balance sheet could be far lower than the actual economic value of the reserves.

Second, investors should be aware that companies using full cost accounting are more likely to have the book value of reserves at a level closer to economic value when compared to a successful efforts company.  Since all exploration costs including dry holes are capitalized into a full cost pool, the book value of reserves will always be higher than under successful efforts accounting unless the company never drills dry holes, an outcome that is very unlikely.  Due to the higher book value of reserves, it is more likely that a full cost accounting company will face impairment charges during periods when commodity prices are very low.

Third, investors must be aware that impairment charges are never reversed when commodity prices increase.  In other words, impairments are one way streets:  Companies must write down the value of reserves if commodity prices make the reserves worth less than book value at the reporting date but can never “write up” the reserves when commodity prices rebound.  As a result, a full cost accounting company will often show relatively low depletion costs in subsequent accounting periods since the book value of the resources subject to depletion have been written down.

Which is More Conservative?

It appears clear that the successful efforts method of accounting is more conservative than full cost accounting since dry holes are immediately recognized as an expense rather than capitalized.  However, defenders of full cost accounting counter than successful efforts may suffer from showing a lower-than-realistic valuation for reserves.  Furthermore, the true cost of developing a “portfolio” of reserves should reflect both successful and unsuccessful attempts.

Management teams who we respect have made different choices.  For example, Contango Oil & Gas Company uses the successful efforts method and Loews Corporation has opted for the full cost accounting method for its HighMount subsidiary.  Ultimately, the choice between full cost and successful efforts accounting involves questions of philosophy as well as conservatism and investors are probably best served by remaining agnostic on the issue.  What is important is to understand the differences between the accounting methods particularly when comparing the book value of reserves and the depletion charges of companies using different accounting methods.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Contango Oil & Gas and Loews Corporation.