Mark Sellers: Exploration of management talent is crucial to success

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Before investing in a company’s shares, it’s important to evaluate the management team.

This is especially true for companies that deal in commodity products or services such as steel, oil or insurance.

In these industries, the winners and losers are separated not by a typical competitive advantage such as unique intellectual property or high switching costs but by the talent of management.

Famous managers of commodity companies include Jack Byrne from White Mountains Insurance, Ken Iverson of Nucor Steel, Herb Kelleher of Southwest Airlines, and Sam Walton of Wal-Mart. The common thread among these chief executives is that they purposely do things differently to everyone else, and stick to their strategy with a laser-like focus in spite of all naysayers.

Once in a great while, an investor may be lucky enough to happen across a manager who may someday become a member of this hallowed group before everyone else finds out.

I believe I have found such a manager: Ken Peak, chairman and chief executive of Contango Oil and Gas. [Disclaimer: Contango is a small-cap company with unpredictable cash flows, and as such, may not be an appropriate investment for some investors. Also, my firm has a position in the stock, so my analysis may be biased.]

Before founding Contango in 1999, Peak spent 27 years in the industry in a variety of financial and executive positions, earned an MBA from Columbia University, and spent three years as a cryptologist in the US Navy.

His company has interests in natural gas exploration projects in the Gulf of Mexico and Fayetteville Shale, owns 10 per cent of a large Gulf Coast liquified natural gas (LNG) terminal being built by Freeport LNG, and has a small venture capital side business that funds early-stage alternative energy companies. Peak controls 19 per cent of the stock, with an additional
6 per cent owned by other officers and directors.

Among other large shareholders, legendary investment firm Ruane, Cunniff & Goldfarb owns about 4 per cent. Though the stock price has run up in the past two months, insiders haven’t sold any shares. The company also has a healthy balance sheet, with little net debt.

Contango has just six employees; there are no in-house marketing, legal, or engineering departments. Most duties are outsourced or done through partnerships. Contango focuses on one function in the value chain: The “E”– exploration – in exploration and production. Exploration is where value is created in the E&P business.

Peak’s strategy is to find the best and brightest geoscientists in the US and partner with them. He gives them access to three-dimensional seismic data, capital to work with, a large personal stake in any successes, and allows them to operate as pseudo-entrepreneurs.

Like Jack Byrne at White Mountains Insurance, Peak is essentially an allocator of capital, putting Contango’s cash into the highest-return projects that are brought to his attention and often selling them off after the initial gas or oil discovery is made and the reserves are proved. In the seven years since Contango was founded, approximately $30m of net capital has been invested in the business. That capital has morphed into a market valuation of $300m – a 900 per cent return on investment and evidence of substantial value creation.

In October, Contango announced that it had made a discovery on its Eugene Island “Dutch” prospect (named after Peak’s father) in the Gulf of Mexico. The stock has since risen more than 50 per cent, but may have further to go.

The company announced that the first well on the Dutch prospect has 75bn cubic feet reserves (25 bcf net to Contango). The value of this to Contango is between $80m and $150m ($5 to $9 per share.)

However, Peak is notoriously conservative about the information he gives to investors and I think the prospect could ultimately turn out to be larger than this. Contango is drilling a second exploratory well in Dutch in December and could drill several more.

The company also has interests in numerous other Gulf leases that have yet to be explored, and Contango has compiled a good track record of success in the Gulf of Mexico.

In addition, Contango has leases on 31,000 net mineral acres in the Arkansas Fayetteville Shale, in the “core” area of the play. Southwest Energy has already proved out most of the core area, so we consider this to be a fairly low-risk project for Contango in spite of a slow start on the first few hundreds of wells.

A conservative value for Contango’s acreage here is between $200m ($13/share) and $300m ($18/share), which could double in a couple of years once the company proves out more of the reserves.

Finally, Contango owns 10 per cent of the Freeport LNG project. Freeport will come on line in 2008, and the LNG capacity there is already pre-sold to Dow Chemical and ConocoPhillips. This low-risk future cash flow stream is worth $50-$80m ($3 to $5/share) to Contango.

Summing up the parts gives a fair value for Contango of somewhere between $21 and $32, compared with a current price of about $19. But this ignores the “option value” of further successful wells in the Dutch prospect, other Gulf leases held by the company and the small venture capital arm with investments in several start-up alternative energy companies.

Mark Sellers is a hedge fund manager with Sellers Capital in Chicago msellers@sellerscapital.com www.ft.com/insidecurve

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