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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. 2. Wide-moat companies that are out of favor
• Paychex, Wrigley, Medtronic, etc.

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

88

19

19

19

19

19

19

19

19

20

98

20

20

19

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

19

20

06

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
02 91 01 93 96 98 99 92 90 20 19 20 20 19 19 19 19 19 19 19 19 19 20 20 20 04 95 94 97 00 05 03

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 89 95 97 99 75 01 03 77 79 81 83 85 87 91 93 05 20 20 19 19 20 19 19 19 19 19 19 19 19 19 19 19 19 20 (E )

Year

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

07

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. 2. 3. 4. Freeport LNG terminal (low risk) Fayetteville Shale acreage (low/med risk) Gulf of Mexico reserves (low/med risk) 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 $400600MM 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.