By Chris Mayer
Natural gas stocks look like gold pieces falling out of Mr. Market's pockets. Time to scoop 'em up, or at least hold what you have. Don't toss 'em out, because Mr. Market has blind spots!
I am still bullish on natural gas, for several reasons. On the supply side, the production decline rates on natural gas fields are steeper than those of oil. In fact, production from many of the new shale plays that brought on so much new supply can drop off as much as 70% after the first year! Plus, the cost structure of the industry is much higher than it ever was. We saw a lot of cutbacks when natural gas prices hit $8. As natural gas prices linger around here in the $4 range, a lot of supply will come out of the market quickly.
On the demand side, natural gas has some favorable tailwinds. It will likely benefit from any emission caps and penalties put on coal. A recent issue of Petroleum Review included a piece about gas- fired power plants entering a new golden age. Then there is the T. Boone Pickens' angle on gas-powered vehicles.
Even now, the growth rate in the number of natural gas-powered buses and trucks in operation is north of 25% annually. And as Pickens has often pointed out, the U.S. has lots of natural gas. So any plan to reduce our dependence on foreign oil must include our vast reservoir of natural gas.
So it seems natural gas has a good future, even though the market relentlessly pounds away at the share price of natural gas producers and drillers. It is a temporary state of affairs. In the private market - where, presumably, buyers and sellers are more knowledgeable - valuations have held much firmer.
Today, investors may look upon the market as they might look on an old friend in a padded cell. It's a bit nutty. Some valuations just don't make sense. The market's estimation of Contango Oil & Gas (MCF:amex) is proof in the pudding.
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How can I recommend a natural gas producer at a time like this, you may be wondering? After all, look at what's happened to natural gas - it's falling like a bungee-jumper…without a bungee cord.
That’s true. But some natural gas companies can make money even at $4 natural gas. Contango is one of them. Its wells are prime examples of "tangible assets that sweat" - physical assets that pour off cash, our favorite kind of investment. Ken Peak, the CEO and largest individual shareholder, says that Contango earns $10 million a month in after-tax free cash flow at $5 gas. That's $120 million a year in free cash flow on a stock that trades for $533 million market cap. In other words, at $5 gas, the stock would be selling trades for less than five times free cash flow!
Of course, Contango’s depressed valuation is no accident. Investors are unloading the stock, partly because natural gas prices have already tumbled and partly because of the fear that they might tumble some more. But knowing what we know about how rapidly depleting natural gas deplete, we are very tempted to believe that natural gas is too darn cheap. If we get to $8 natural gas, Contango will gush cash flow.
Its production costs are about $2.18 per mcf, all in.
Natural gas ought to correct very quickly this time around. Annual natural gas depletion in the U.S. is around 36% per year. So it wouldn't take a lot of production cuts to quickly get a steep drop in supply.
As it is, the company has zero debt, another rarity. As of December 30, it had $77 million in cash, or nearly $5 per share.
And I admire Peak, who is one of those smart eggs who seems to coolly put his money in the right places time and time again. His track record is impressive. In December 2007, he sold Contango's shale acreage for $338 million. Contango's cost was only $38 million, so he turned a net profit of $300 million for Contango. In February of 2008, he sold Contango's interest in an LNG project for $68 million.
Contango's cost basis was $2 million. Contango itself is a great story of wealth creation. Peak started it in 1999. The total capital put into the business was $50 million - never a cent more than that. Today, Contango's market cap - even at this depressed level - is over $500 million.
How did Peak create such wealth? King Arthur had Excalibur, Charlemagne had Flamberge and Ken Peak has Dutch and Mary Rose. Big finds in these fields in the Gulf of Mexico powered the wealth creation story at Contango. The company now has proven reserves of 369 Bcfe. So based on Contango’s current market cap, you get these reserves for only about $1.50 per Mcf - a super cheap price. These are low-cost and high-price reserves. It's the good stuff, to put it bluntly. "You get 22 [Mcfe] every time you buy a share," says Peak.
The stock is so cheap Peak worries some deep-pocketed bully will come along and try to steal it. Peak recently adopted a shareholder rights plan that makes such a takeover more difficult. As he put it: "Because the stock price is so far down, I didn't want the company to be vulnerable where some of the stockholders, including me, are taken advantage of."
The plan would normally bother me, but not in this case. Peak wants to get paid for what he has, and he knows what it is worth. Management owns 24% of the company. When they get paid, so do we.
He thought about selling Contango earlier in 2008, but couldn't get a price he was happy with. "Our seven wells [alone] are worth billions," he declares. Again, the market says Contango is worth only $544 million as I write. Ultimately, I think Peak will sell the company. I think the purchase price will be at least $95 per share. But even if that doesn't happen, Contango is a great bargain here at the current quote of $33.
Contango is also buying back its own stock. Peak says Contango enjoys a 50% after-tax return on these purchases. With the share price so low, buybacks add a lot of value to net asset value (NAV) because Contango is buying proven natural gas reserves at prices much cheaper than what it would cost you to find them with a drill bit. Plus, Contango has exploratory blocks still in the hopper. So there is more upside here.
Stay the course.
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