Sellers Capital, LLC

My Favorite Stock
by Mark Sellers
161 N. Clark, Suite 4700
Chicago, IL 60601
(312) 523-2160
msellers@sellerscapital.com

This document is for information purposes only. It is not an offer of, or a solicitation for, the sale of a security, nor
shall there be any sale of a security in any jurisdiction where such an offer, solicitation, or sale would be unlawful. An
investment in The Sellers Capital Fund, LLC (the “Fund”) may only be made pursuant to the Fund’s Confidential
Information Memorandum and Limited Liability Company Agreement (the “Offering Documents”). Prospective
investors are strongly urged to review carefully the Offering Documents and the relevant subscription agreement prior
to investing.
 Table of Contents
• Overview of Sellers Capital investment
philosophy

• What is there to like about E&P stocks?

• Natural gas fundamentals – quick overview

• My favorite stock
 Sellers Capital – philosophy
• We buy two types of companies
1. Wide-moat companies that are out of favor
• Paychex, Wrigley, Medtronic, etc.

2. Small-cap companies selling at or near tangible liquidation

value.

• We hold a very concentrated portfolio

• We make big bets
• We don’t diversify
• We don’t think volatility = risk. We like volatility.
– Risk = permanent capital impairment. We spend nearly all our
time figuring out the likelihood of permanent capital
impairment.
Bet sizing and risk management
• The key is downside risk. If you can find something with very small
downside risk, the upside potential is less important.
• West Coast Asset Management – Focus on the downside and the upside
will take care of itself. We live by these words.
• Sellers Capital - only bet when there’s at least a 3:1 reward:risk ratio.
• Buffett - Rule #1: Don’t lose money.
– Rule #2: see Rule #1.
• Kelly Formula – Never bet unless the odds are in your favor.
• Monish Pabrai: Entrepreneurs make big bets when the downside is small,
upside is large.

The secret to successful investing: Only make bets when the odds are highly
skewed in your favor. Make big bets because these opportunities are
exceedingly rare. If you avoid permanent capital impairment, you will do well.
 Why We Invest in
Nat. Gas E&P Stocks
• After 18 months studying the industry intensively, we think it’s within our
circle of competence.
• We’re NOT betting that NG commodity price will go up, simply that it won’t
stay below $6 over the long-term.
– You can hedge by shorting a basket of large-cap natural gas stocks, or shorting
the Natural Gas ETF (ticker: UNG).
• These stocks are volatile and that presents opportunity.
• Talented management is more important than in most industries -- the
market often doesn’t give enough credit for great management.
– This is a market inefficiency that can be exploited.
• Lots of dumb money playing around with these stocks, lots of momentum
trading.
• These cos. have a tangible asset value that can be realized easily. Assets
can be easily converted into cash without discounting them. (try doing that
with retail inventory.)
• Free options are sometimes lying around waiting to be picked up. In our
experience, that’s rare in other industries but not in this one.
Natural Gas: Industry Overview

• Running on a treadmill. Depletion rates

up from 17% to 32% over past 15 years.
– Low-hanging fruit has been picked.
– As Gulf of Mexico depletes, onshore NG
becomes more important. But onshore
wells have a much steeper decline curve.
 Natural Gas: Market Overview

• Finding new gas reserves more

expensive each year. F&D costs up
60% in 2006 vs. 2005. (Calyon
Securities)
Calyon Securities (January 11, 2007): F&D Costs likely rose 60% in 2006, to $3.50/MCF
 Natural Gas: Market Overview

• Rig count has doubled in past 5 years,

yet production up only slightly.
– New wells not as productive as they used
to be
Source: CSFB report 1/12/07
 Annual U.S. Natural Gas Production

25,000,000

24,000,000

23,000,000

22,000,000

21,000,000

20,000,000

19,000,000

18,000,000
80

82

84

86

90

92

94

96

00

02

04

06
88

98
19

19

19

19

19

19

19

19

19

19

20

20

20

20
Source: U.S. Gov’t Energy Information Administration
 U.S. Gulf of Mexico - Total Reserves (Bcf)

34,000

32,000

30,000

28,000

26,000

24,000

22,000

20,000

18,000
90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05
19

19

19

19

19

19

19

19

19

19

20

20

20

20

20

20
Source: U.S. Gov’t Energy Information Administration
 Natural Gas: Market Overview

• LNG – This is only a solution for U.S.

supply needs when gas prices are high.
– U.S. having a hard time getting LNG
because of high shipping costs, distance
from supply (Middle East is closer to
Europe & Asia than U.S., so lower shipping
costs.)
• If nat. gas prices go down, LNG
shipments do too, reducing supply.
 Annual LNG Supply to U.S.

700,000

600,000
Total LNG Imports to U.S.

500,000

400,000

300,000

200,000

100,000

0
1999 2000 2001 2002 2003 2004 2005 2006

Source: U.S. Gov’t Energy Information Administration

 Natural Gas: Market Overview

• Canadian imports (15% of U.S.

supply) likely to fall dramatically in
coming years because of:
1. Falling U.S. dollar.
2. Rising labor costs.
3. Oil sands NG usage.
 Canadian Natural Gas Imports to U.S.

4,000,000

3,500,000
Annual Imports to U.S. (Mcf)

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0
73

75

77

79

81

83

85

87

89

91

93

95

97

99

01

03

05

)
(E
19

19

19

19

19

19

19

19

19

19

19

19

19

19

20

20

20
07
20
Year

Source: U.S. Gov’t Energy Information Administration

 Natural Gas: Market Overview
• Natural gas clean burning – Coal is cheaper but
politically sensitive. Global warming.

• M&A activity is picking up.

– “Reserves are cheaper on Wall St. than they are in the
ground.” (CSFB Jan 4, 2007.)

• Factors affecting pricing: Short-term = weather.

Long-term = increasing depletion rate, more rigs to
get same amount of gas, rising F&D costs, LNG
shortfall, increased power plant usage, avoidance of
greenhouse gasses.
 Natural Gas: Market Overview

• Bottom line:
We feel that the long-term floor for NG
prices is around $6 for companies to
achieve 10% ROE. If prices fall below
that for long, onshore (higher cost)
wells get shut in, supply drops (as in
fall of 2006).
 Characteristics of E&P Stocks
• Volatile stock prices. Daily price swings based on
weather forecasts, futures trading.
– NG stocks trade partly based on front-month NG and oil futures
prices. Long-term strip pricing doesn’t seem to matter.
– NG stocks are more correlated with oil prices than NG prices!
– With volatility and intense short-term focus comes an opportunity
for time arbitrage.

• These companies have tangible asset values, hard

assets. Value changes much more slowly than stock
price.

• Bill Miller: The market doesn’t pay for optionality.

– Nowhere is this more true than with oil/gas companies
 Unproven prospects are a “free option” –
the market won’t pay for them until proven…

Reserves proven

Reserves unproven

Huge volume spike. No one wants to

buy until drilling results certain.
 My Favorite Stock
Contango Oil & Gas (Ticker: MCF)
• Market cap: $450MM
• No analyst coverage
• 16.8MM fully diluted shares 2001,
16.9MM diluted shares 2007. Virtually no
increase in 6 years.
• $30MM net debt.
• Insiders own ~25%, Sellers Capital owns
~10%, West Coast Asset Mgt. owns
~7%, Ruane, Cuniff owns ~4%.
 Company History
• Founded by Ken Peak in 1999.
• Company started with $30MM capital, has grown to
$450MM market cap.
• Focuses on highest ROI part of the E&P value chain –
exploration
– There’s a huge difference between the best and worst
exploration companies. Con artists attracted to this industry.
It’s common to overpromise and underdeliver.
– E&P is both art and science (similar to stock investing).
• Contango has 7 employees, a small office in Houston
– outsources everything except planning and idea
generation.
 Ken Peak
• Chairman and CEO of Contango since its formation in September
1999.
• A fan of Warren Buffett, thinks similarly. Very conservative when
talking to investors, doesn’t “pump” the stock.
• Entered the energy industry in 1972 as a commercial banker and
held a variety of financial and executive positions in the oil and gas
industry.
• Served as an officer in the U.S. Navy from 1968 to 1971.
• BS physics Ohio Univ. (1967), MBA Columbia (1972).
• Director of Patterson-UTI Energy, Inc.
• Owns 20% of stock, takes no cash salary (his ex-wife gets his
salary).
• Borrows money to live on using his stock as collateral, owes his
bank $5MM currently. Has never sold a share.
 Contango – company philosophy
1. Give smart people capital, give them
large incentives for doing well, and then
let them do their thing. (Reminiscent of
Buffett.)
2. Virtually all the industry's value creation
occurs through the drilling of successful
exploratory wells.
 Contango Oil & Gas

• Company valuation the sum of 4 parts

1. Freeport LNG terminal (low risk)
2. Fayetteville Shale acreage (low/med risk)
3. Gulf of Mexico reserves (low/med risk)
4. 70 unproven Gulf of Mexico lease blocks
(high risk).
 Fayetteville Shale (Arkansas)
($120MM to $600MM)
• Drilling ~5000 feet down, into shale rock that contains trapped gas.

• Contango has 31,000 net acres in the “core” area of the play.
– In the core area, wells are low risk. Southwestern has had 98% success rate
drilling in core area. Contango acreage contiguous to Southwestern’s.
– “Manufacturing” gas.
– Partnered with George Mitchell – Father of the Barnett Shale

• Low to medium risk -- Southwestern has already proven out this area, for
the most part. By early 2008, acreage should be fully proven out.

• Valuation range: $120MM today (acreage not proven out) to $400-

600MM when fully proven 12-18 months from now.
– Southwestern current market cap implies value of ~$7000/acre
– Recent transactions in Barnett Shale for $15-$25k per acre.

Free option: Although it’s highly likely that most of the

Fayetteville acreage will be proved out within 12-18 months, the
market is valuing this option at $0.
 Freeport LNG Terminal
($75MM to $200MM)
• This is one of the first LNG terminals built in US since 1980’s.
• Contango invested $3MM in this terminal project in 2001, now worth
25x this amount.
• NIMBY issues, hard to get these approved.
• Low risk. Long-term annuity contracts with Conoco and Dow locked
in. Phase I of Freeport done early 2008, Phase II and Phase III won’t
be built unless demand for LNG is there.
– Customers are also lenders and equity holders.
– Contracts with Dow, Conoco are “take or pay” so LNG supply
issues don’t affect value of Contango’s investment.
• Annuity of $7-$8MM per year starts 2008, goes for decades.
• Market value of Phase I: $75MM to $125MM.
– (Lehman analyst implied value of Freeport $75MM, JP Morgan
analyst $125MM.)
• Free Option: Phase II and Phase III of Freeport will be built if LNG
becomes a viable option in the U.S. This would double or triple
the value of Contango’s investment in Freeport.
The market is valuing this option at $0.
 Existing Gulf of Mexico Reserves
($455MM to $650MM)
• Gulf drilling expensive, risky.
• Contango targeting Miocene gas deposits (16,000’ +) in shallow Gulf waters just off
the coast.
• Have hit gas on 4 out of 6 Gulf wells drilled so far (67% success rate).
– Dutch one of the largest discoveries in the Gulf shelf in more than 10 years. This is a
monster find.
• Company using new seismic technique that they won’t disclose to us. Has resulted in
high success rate.
• Proven Gulf reserves approx 53 Bcf. Market value at $5.00/mcf = $265MM
– Dutch find (recent large discovery) worth $5/mcf because of high-value “condensate” not
included in reported reserve numbers (ethane, propane, butane.)
– Some recent Gulf of Mexico transactions at $4-$5 per proved mcf.

• Probable Gulf reserves booked 77 bcf. Market value @ $2.50/mcf = $190MM

• Total liquidation value of Gulf reserves = $455MM

• Free option – 77 bcf PROBABLE reserves that will be proven within 12-15
months. Incremental value = 77 bcf * $2.50 addt’l value per Mcf = $195MM.

THE MARKET IS VALUING THIS OPTION AT $0.

 70 Lease Blocks – Gulf of Mexico
• Cost basis = $35MM. Could be sold today for $100MM
because of seismic data and Contango’s track record.
• Instead of selling leases, Peak says Contango plans to
drill 15-20 of these lease blocks over next few years.
• Assuming 15 wells drilled, 50% “hit” rate (conservative),
30 bcf average per lease block (conservative) = total
Gulf reserves yet to be discovered of ~200bcf.
– Future value of these reserves = 200 bcf x $3.50/mcf = $700MM
• Discount this back 3 years at 15% discount rate and
present value is $450MM - $100MM drilling costs =
$350MM net present value.

THE MARKET IS VALUING THIS OPTION AT $0.

 Sum-of-the-Parts Valuation
• Fayetteville shale $120MM - $600MM
• Freeport LNG terminal $75 MM - $200MM
• Gulf of Mexico reserves $455MM - $650MM
• Gulf of Mexico leases $100MM - $350MM
Total (pre-tax) $750MM - $1,800MM
Minus Taxes ($150MM- $600MM)
Total (after-tax) $600MM - $1200MM
• Shares outstanding: 16.9MM
• $35.50/share current liquidation value.
– Current Stock Price: $30/share.
• $71/share value if all options work out. Most likely
value today in the $50-$60 range.
Contango is selling 16% below its current after-tax
liquidation value and 50% below its fair value.
 Option value – What’s priced in?
• Another way to think about it – how much is market paying for
optionality?

• Enterprise Value 5/8/07: $500MM

• Current after tax liquidation value: $600MM
• So, implied option value: $(-100MM)
Market is valuing these options at less than zero.
• Based on our calculations the option value, over and above liquidation
value, is $600MM
– So the market is giving away ~$35/share in option value.
• Options valued at less than $0 by the market:
– Further success in the Fayetteville shale despite 98% drilling success
rate. Let’s say odds are 75% that they have success drilling future wells.
– 70 Gulf lease blocks not yet drilled on despite 67% success track record
– Possible Phase II of Freeport LNG terminal – let’s say 33% odds.
– Conversion of 77 bcf Gulf of Mexico “probable” reserves to “proven”
reserves -- 80% probability of success.
– NG price volatility (company is unhedged). 50% chance NG prices
remain above $7 long term. (investors can hedge out ng price risk)
If all of these options expire worthless, the stock is roughly fairly valued.
In most likely scenario, stock is 40-50% undervalued.
 Contango – Exit Strategy
• Peak is very sensitive to taxes because he’s the largest
shareholder.

• Tax-free spin off Freeport LNG stake into an MLP

(publicly traded?) Timeline: early/mid-2008
• Swap Fayetteville acreage for shares of large-cap
company once proved out, pay out shares as dividend.
Timeline: mid-2008.
• Continue drilling in the Gulf.
• Eventually, Peak will sell the Gulf assets and retire (he’s
62) but not until the value is maximized (3-5 years?)
• Russell 2000 inclusion – next month? (June 2007)
 Sellers Capital, LLC

My Favorite Stock
by Mark Sellers

161 N. Clark, Suite 4700

Chicago, IL 60601
(312) 523-2160
msellers@sellerscapital.com

This document is for information purposes only. It is not an offer of, or a solicitation for, the sale of a security, nor
shall there be any sale of a security in any jurisdiction where such an offer, solicitation, or sale would be unlawful. An
investment in The Sellers Capital Fund, LLC (the “Fund”) may only be made pursuant to the Fund’s Confidential
Information Memorandum and Limited Liability Company Agreement (the “Offering Documents”). Prospective
investors are strongly urged to review carefully the Offering Documents and the relevant subscription agreement prior
to investing.