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Tarpon Folio
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In This Issue

bullet Cale's Notes: Rocks, Crowds and Stewards
bullet Get To Know Your Company: Dancing with Contango Again
bullet About the Tarpon Folio: More on our flagship Spoke Fund®

Special Update
Published 3/18/2017

csmith@islainvest.com
(305) 522-1333


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Cale's Notes

Dear Investors,

The world is going to be temporarily short of oil at some point in the next two years.

That is not a forecast. It’s just math.

Oil markets the last few weeks have again been cowering in fear due to concerns about U.S. oversupply. Traders appear, once again, to have temporarily lost focus on the inevitable – that tightening global inventories led by OPEC production cuts, non-OPEC production declines, the tenacity of the decline curve and continued oil demand growth are setting the stage for a significant oil price rally in 2017 as oil markets balance.

In spite of the recent volatility in oil prices, the underlying fundamentals for oil have improved. We are still in the early innings of a multi-year bull market for oil. This most recent sell-off has been driven by technical traders and the fast money crowd misreading some recent U.S. crude inventory builds.

Impatient traders want immediate and incontrovertible proof that the OPEC cuts are working, but seasonal refinery maintenance and continued high U.S. imports have kept crude levels here from falling as fast as hoped. This twitchy crowd has also been surprised – no, shocked! - that large volumes of oil previously stored in large ships moored offshore would be sold onshore when the crude futures curve flattened and storing oil became less profitable.

The calendar will soon correct both situations. Nonetheless, the reaction to those surprises caught a lot of bullish speculators off-guard, too, exacerbating the volatility and sending oil down 9% in a week. This despite no material negative news. Again.

It’s annoying. I get it. But I nonetheless remain bullish about oil and Tarpon in 2017, and I recently made our first trades since last August. We were buying this week.

I will update you more formally on Tarpon and our recent changes after the end of the first quarter. In this letter I thought I’d try to help alleviate any oil-induced angst you might be feeling by skipping the macro analysis and focusing on one of our companies. Given this week’s buying, there is one in particular that seems worth discussing.

First, though – a reminder in the form of one of my favorite investing quotes:

“If you run through a dynamite factory with a lit match, you may survive, but you’re still an idiot.”

The Gameplan

To profit from the greatest oil market bust in modern history, my investment approach has looked like this:

Focus on good rocks. Ignore the crowd. Find the stewards.

Focus On Good Rocks.

Unconventional oil production in the U.S. has essentially become a manufacturing business, where cost control and efficiency are critical. At this point in the cycle, though, further efficiency gains are capped and the ability for management to further improve margins has disappeared.

The key to E&P performance, therefore, is not found in a company’s operations. It is found in the rocks.

Good rocks are the only true competitive advantage in this industry. Geology is the most important driver of internal returns at an E&P.

Good rocks can make a weak management team look brilliant, but not even the best managers can outrun bad geology.

Ignore the crowd.

There is a remarkable degree of groupthink among E&P investors.

Few seem to even bother attempting to objectively value shale assets by assessing well economics, leasehold quality, or a company’s development plan.

Instead, most energy investors are momentum traders and seem to focus only on the daily trajectory of oil prices. Technical trading is rampant. Those who do consider company fundamentals are typically growth investors, emphasizing production growth and inter-company comparisons above all else. The E&P landscape ends up being bifurcated into popular, large, high multiple stocks…and then the island of misfit toys. Today, the former group appears overvalued, while the misfits are dirt cheap.

Crowds have pro-cyclical biases that can be exploited by patient investors. Having a long-term time horizon and a commitment to prioritize valuation above popularity is a significant advantage.

Find the stewards.

After geology, the quality of a management team is the next most important factor in evaluating U.S. E&Ps.

The best management teams keep debt low, issue stock rarely, achieve a high velocity of capital, and target a return of capital on their wells in two years or less. Rapid payouts mean growth can be financed with internally generated cash flows, as opposed to stock sales and/or debt. And low debt is an advantage because it allows an E&P to engage in counter-cyclical behavior; i.e. be greedy when others are fearful.

I personally believe that all phases of an E&P business should be focused on intelligently growing the assets that cash flow today. These assets in industry parlance are called PDP (Proved Developed Producing) reserves – which, simply put, are live oil wells. These assets are distinct from other types of reserves in areas that may not if ever be drilled.

We want PDPs to grow on a debt-adjusted, per share basis – because any company can grow by leaps and bounds if capital is constantly injected into it. Not all growth is good. If capital costs more than it earns, growth is by definition destroying value. Too many E&P management teams learn this the hard way.

I believe per share growth in PDP reserves should a the primary focus of E&P management because (a) free cash flow at an E&P is the direct result of having achieved critical mass in PDPs, and (b) there is a strong historical relationship between E&P share price performance and growth in PDP reserve value (less net debt) on a per share basis.

Over the long-term, the market rewards management teams who serve as good stewards of their firm’s capital. So we focus there, too.

The Proof in the Pudding

This is the same approach that led to our investments in companies like Resolute Energy and Clayton Williams last year – and, to be fair, a couple of duds, too. I’m okay with the rare bad outcome, though, if we have a process that on balance works real well. And one of the reasons I think we remain very well positioned today is because we still seem to be competing against a slew of panicked, sweaty guys, running around the factory clutching matches.

To be clear, I am no apologist for the shale industry. It is politically controversial, dominated by fast money players and deeply in league with Wall Street. The valuations of too many of the big oil frackers still seem odd to me. And there are absolutely days where I look forward to one day returning to investing in much more boring companies.

But some small E&Ps still represent once-in-a-decade opportunities. And I feel like I owe it to you all to do my best to find them.

All of which brings me back to a once-familiar name in the Tarpon Folio:

Contango Oil & Gas

Tarpon first held shares in Contango (MCF) eight years ago.

Some of you may recall that CEO Ken Peak spoke at length about Contango at our first annual investor meeting. He came to Islamorada right after a trip to Mexico, and told the story of how, in his words, he “took every dollar I had and pushed that little pile into the center of the table” to get Contango started.

Ken was unique among E&P CEO’s because he was gloriously frugal, invested the firm’s capital exceptionally, and adamantly believed that the only true competitive advantage in a commodity industry like natural gas or oil was to be the low-cost producer.

He also named his offshore drilling sites after characters in The Big Lebowksi.

Ken passed away from brain cancer in 2013. We’d previously sold our shares of Contango, but Margie and I sent flowers to the funeral, and I then put Contango on my watch list, where it stayed ever since. Until last week, when we became owners for the second time.

After Ken died, Contango seemed to drift. They merged with an onshore company having lots of land but not much cash. Then a new management team I did not know. Bad luck on a few offshore wells came next. And in the meantime, the juggernaut that was the Marcellus shale came into its own, forever changing the dynamics of natural gas production in the U.S.

As it turns out, though, Contango wasn’t really drifting. I just wasn’t paying close enough attention. That merger Contango pulled off was a coup; good oily rocks, a billion dollars of reserves, and an income tax shield to boot. And though I didn’t know management, they were put in their jobs by Howard Marks – a value investor I very much respect and whose firm still owns a significant chunk of Contango shares.

I suppose my concern about Contango after Ken died was that the new guy could never replace the legend. I just sort of assumed whoever was CEO after Ken would be like a quinoa burger. Turns out, though, there is a chance this guy might be Tom Brady.

I also eventually had to concede that that while the old Contango may have been extremely well-managed, it was also pretty narrowly focused in the Gulf of Mexico. That Contango had good assets with great cash flows, but no obvious place to reinvest that cash for significant growth over the long-term.

Plus, due to the rise of onshore shale, that market has determined that excellence in offshore exploration is a rapidly depreciating skill set. The industry just doesn’t need good wildcatters like Ken anymore.

The merger Contango did right after Ken’s passing was quite rational, too, though I didn’t grasp it before; a diversified mix of offshore low cost reserves and unconventional onshore reserves would give the company an asset base which might be a bit sprawling, but it could probably withstand just about anything. And it did. A year ago, when oil hit $26 a barrel, Contango’s operations still booked $8 million in cash flow for the quarter.

And that little stress test made me reconsider my earlier belief that Contango was spread too thin around the country.

In the end, I saw the company’s approach under Ken Peak as the never ending quest to add low cost, profitable reserves. And they have really continued to do the same since, only onshore, instead of in the Gulf of Mexico, only I didn’t see it until a deal they did last summer.

And then this week, Contango shares got too cheap to resist.

So, welcome to the new Contango – cheaper than ever, still very well run, and ready to grow the right way.

Please scroll down to read more about Contango Oil & Gas.

Or to download my ten page write-up as a PDF, please click here.

Please let me know if you have any questions. Thank you.

- Cale

Get to Know Your Company

Dancing With Contango Again

Introduction

Contango Oil & Gas (“Contango” or “MCF") is a small, well-managed, conservatively financed U.S. oil and gas exploration and production ("E&P”) company. The company’s common equity is trading approximately 85% lower than three years ago, due primarily to (1) a collapse in oil prices and continued skepticism that oil will recover above $50 per barrel, (2) a geographic and production mix viewed as inferior to single-play oil frackers, and (3) limited analyst coverage and a ~$150M market cap.

In spite of resilient cash flows and a stunningly low-cost acquisition of top tier acreage in the Permian Basin last July, current valuation levels for Contango are at thirteen-year lows. Contango shares are currently selling at 0.5x PV-10 value of 12/31/16 PDP reserves and at 2.7x estimated 2017 EBITDA.

The market is assuming that Contango’s business is broken with oil prices under $50 and nat gas less than $3.00, and/or that microcap U.S. E&Ps in general are permanently impaired.

In contrast to the market, I believe that Contango equity will provide significant returns in 2017 at current WTI and nat gas strips. Contango is unique among small independent oil and gas production companies given its low debt, disciplined management, excellent assets, and predictable high margin cash flows from legacy offshore gas production. With ample liquidity, no outstanding bonds and significant capacity on its revolving credit facility, the company has considerable flexibility to restart its drilling program and pursue strategic acquisitions like its recent Permian purchase.

Contango shares are likely multi-baggers several years out should the WTI strip prove too conservative. While oil markets the last six weeks have once again been cowering in fear due to concerns of U.S. oversupply, investors appear to have temporarily lost focus on the inevitable; tightening global inventories led by OPEC production cuts, non-OPEC production declines and continued oil demand growth are setting the stage for a significant oil price rally in 2017 as oil markets balance.

Contango’s current valuation is compelling - even assuming today’s strip is an accurate forecast. A significant gap exists between the company’s current enterprise value ($245M) and projected PV-10 (PDPs only, current strip) at the end of the year ($138M). Assuming no equity issuance nor monetization of any hedging gains, that gap represents a $4.22 increase in intrinsic value per share in 2017 on a stock currently trading at $5.95 per share - or 72% upside. Pricing increases above the current WTI strip represent potentially significant further equity appreciation at Contango.

Contango equity offers asymmetric returns of 75% – 100% upside in 2017 and is well-positioned to accrue value at an accelerated pace beyond ’17 due to a cyclical upturn in oil. The downside is limited; Contango currently trades at half of liquidation value and $4.19 was the floor in the stock in early 2016 when oil briefly touched $26 per barrel - well prior to Contango’s transformative deal in the Permian.

I believe price support exists for the shares at levels approximating today’s stock price due to (a) valuation, (b) imminent draws in U.S. crude inventories, and (3) supportive major equity holders in Oaktree Capital Management, which owns 5.1% of outstanding equity and has a board seat, and Ariel Investments, which owns approximately 14.8% of the common.

The Contango CEO owns 1% of the common and management in aggregate owns 3.5% of the company. Management’s strategy is to essentially use the company’s offshore natural gas production as a cash cow to fund its onshore development and acquisition activities.

Stock is issued very sparingly; prior to the company selling 5 million shares for proceeds of ~ $50 million last year to buy 5000 net Permian acres (later adjusted to 6600 net acres) at an extremely good price, the last equity sale of any kind by the company was an issuance of $30M of preferred stock to private investors back in 2007. In each year from 2008 to 2015, Contango bought back its shares in the open market.

Contango uses the successful efforts method of accounting and reserves auditors are Netherland Sewell (onshore) and William Cobb (offshore).

Production and reserves in 2016 were roughly split 60% offshore and 40% onshore with a product mix of approximately 74% natural gas and 26% liquids – a high nat gas mix consistent with the cessation of all new onshore oil drilling activities at the end of 2014. Management intends to significantly increase oil production in the Permian in 2017 and beyond. For 2017, the company has nat gas swaps on 50% of its PDPs at $3.51 and has similarly hedged 54% of PDP crude production at $53.95.

Contango's debt as of 12/31/2016 was $54.4 million, entirely drawn from an RBC revolving credit of $140 million that matures in October of 2019. The next redetermination date is 5/1/2017 and no changes are expected. Contango's debt has favorable interest terms at LIBOR +, and the weighted average interest rate for the company in Q3 ’16 quarter was approximately 3.9%. Debt to EBITDAX using Q3-16 as a run rate was approximately 1.8x; interest coverage is a non-issue. Contango plans to fund their 2017 capital program with internally generated cash flows. With low leverage and strong coverage, Contango stands out among its peers.

The 2016 10-K has not yet been published at the time of this write-up, but as of December 31, 2015, Contango had net operating loss (NOL) carryforwards of $140.4 million.


To download read the rest of my write-up on Contango, including the five things that I think make it a compelling long today and six valuation hacks, click here to download a PDF copy. And please let me know what you think!

About Tarpon

The Tarpon Folio is an innovative, investor-friendly alternative to the traditional actively managed mutual fund. It's built on a model we call a Spoke Fund®.

Spoke Fund® is a group of separate investor accounts linked to a portfolio containing a significant portion of the net worth of the portfolio manager. Cale Smith at IIM is the creator and owner of this trademarked and proprietary approach to better transparency and integrity in investing other people’s money.

Fees for Tarpon are 1.25% of assets annually, assessed on a monthly basis. Turnover, taxes and trading are minimized in the fund, which uses a long-term value investing strategy.

For more information, visit our website.

Here is our privacy policy, our Form ADV and our Fiduciary Oath.

Disclaimer

Historical performance data above represents performance results as reported by the portfolio identified. Performance results are for illustration purposes only. Historical results are not indicative of future performance. Positive returns are not guaranteed.

Individual results will vary depending on market conditions and timing of initial investment. Investing may cause capital loss. The S&P 500, used for comparison purposes, is significantly less volatile than the holdings of the funds listed. The performance data is net of all fees reflecting the deduction of advisory fees, brokerage commissions and any other client-paid expenses. The performance data includes the reinvestment of capital gains and dividends.

The publication of this performance data is in no way a solicitation or offer to sell securities or investment advisory services.

© 2019 Islamorada Investment Management. All rights reserved.

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