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E&P 101 (The Short Course)
E&P 101 (The Short Course)
Contango is in the "upstream" sector of the U.S. energy business, as opposed to the refining and other "downstream" sectors of marketing refined products such as heating oil, gasoline, and distribution of natural gas. The exploration for oil and natural gas is a very mature business (N.B. mature does not equate to stable) that has been around for over a hundred and forty years. As a result, all of the easy to identify and obvious oil and gas fields have already been discovered. Thus, the U.S. domestic industry has had to rely on improving technology to economically find and produce increasingly geologically complex and smaller oil and gas accumulations.
Revenues
Oil and natural gas are commodities that trade off of highly visible reference prices (Nymex futures pricing, field postings, and various pipeline hubs) with adjustments for gravity, Sulfur, etc., and nearness to a pipeline in the case of crude oil; and btu content, impurities, etc., and nearness to a pipeline in the case of natural gas. Contango has no ability to increase the market price of oil or natural gas, but there are ways to improve the company's margins through diligent marketing, laying pipeline gathering systems, building gas plants and other strategies to capture a share of the "downstream" value chain.
Competitive Advantage
What is Contango's strategy to achieve a competitive edge? In all commodity businesses, the only real competitive advantage is to be a low-cost producer. Contango's strategy to be a low cost producer includes the following: F&D cost - shift as much as possible of the day-to-day people costs associated with generating and screening prospects through its alliance with JEX. Stay focused on the funding and drilling of a prospect, the most value added part of the value chain. Make sure the explorationists who work for us have the right stuff. Interest Cost - keep leverage modest. Debt can allow a company to grow faster and sometimes earn a higher ROE. The trade-off, though, is a loss in financial flexibility and an inability to jump on opportunities. Also, time is not on you side when you're over-leveraged, and in a highly cyclical business, timing cycles is critical to success.
Competition
There are two types of competition in the oil and gas business. The first is present in all industries - other companies who are competing to generate and control the same assets, or in our case, the same oil and gas leases, prospects or producing properties that we are seeking. Virtually all of these companies are significantly larger and better capitalized than Contango. Moreover, they are staffed with smart, competent individuals who are dedicated to building their companies. As formidable as these companies are, however, they are not our only or necessarily most formidable competitive challenge.
Competition (Contd)
The second challenge is to avoid overpaying for leases, seismic data and producing reserves, and managing our capital and the risk profile of the wells we decide to drill. There are always lots of developing "hot plays" and "deals" available in the oil and gas industry. The scarce skill set and managements largest value added opportunity/ challenge is sorting through these "hot plays" and "deals" and avoiding the temptation to drill the inferior reward/ risk prospects. Of course, no one purposefully drills a dry hole, and identifying the wells that are going to be successful in advance of drilling is impossible because of the many variables involved and the numerous and entirely feasible interpretations of both reward (expected profit) and risk (the probability of an undesired outcome). Nonetheless, this skill set, or combination of skill, hard work, and perhaps luck is the single most important ingredient for success in the E&P business.
Summary
In summary, we're optimistic about the opportunities we think are in front of us, despite being fully cognizant that most independent oil and natural gas exploration and production companies over the last two decades have been "value destroyers" rather than "value creators". We think a renewed industry commitment to profitability is absolutely essential. We believe Contango's sole focus on the highest value added component of the value chain, and low cost structure are key to this profitability. Finally, and perhaps the single most important investment criteria of all: Incentives Drive Behavior. Contango s management and the Board of Directors own collectively 60% of Contango's stock and are incentivized to grow asset value and earnings per share.