Contango Oil

1
Contango Oil Gas

• The following presentation was given by Ken
  Peak, Chairman and CEO of Contango Oil Gas,at
  an Energy Symposium at the Harvard Business
  School on September 28, 2002.

2
Natural Gas Oil Exploration Business

• Its a lousy business
• Commodity business
• Violent swings from surplus/ shortage/ surplus,
  etc.
• Depleting assets/ capital intensive
• Highly price elastic
• High risk
• Long history of not earning its hurdle ROR
• Surprisingly low barriers to entry
• 100 hunters 2 rabbits
• Only low-cost suppliers win
• Business is only and always about value creation

3
THE OIL MYTH

• High oil prices are bad for natural gas producers
• Oil the last 100 years has been 20/barrel
• At 28/barrel last two years 100 billion tax
  increase in U.S. alone
• Natural gas growth market is electricity GNP
• Nat Gass real competition is coal, nuclear,
  Canada, and easy money

4
STRATEGY

• TWO CORE BELIEFS
• In a commodity business there are no
  competitive advantages. Only lowest cost
  producers survive and prosper
• The industry's value creation event is the
  turning to the right of the exploration drill bit

5
Value Creation/ Destruction

• What does Contango do to create value?
• Find and develop natural gas and oil at an
  economically attractive price In a 3 gas world
  1.50/mcfe finding cost is pretty good
• What can happen to destroy value?
• Drill a bunch of dry holes
• Run out of money
• Have too much debt/GA
• Big drop in natural gas prices NOT!
• Murphy

6
Before You Graduate, Learn A Little About

• Accounting/ Finance
• Statistics/ Probability
• Human Behavior

7
How And What You Count Counts

• Accounting book value bears only a coincidental
  relationship to intrinsic value
• Full cost vs. successful efforts
• Never, never, never let accounting consequences
  influence a decision.
• If thought corrupts language, language can also
  corrupt thought
• George Orwell

8
Finance 101

• How do you value a depleting asset oil and gas
  exploration company?
• Present value of future cash flow plus the black
  box
• GA costs going-forward 2.0-2.5 million /year.
  What do shareholders get for this expenditure?
• Clues to whats in the black box
• Managements integrity
• Macro environment
• Industry environment
• Managements track record
• Managements incentives

9
Human Behavior 101

• Overconfidence
• Immediate gratification
• Loss aversion
• Incentives everywhere, only, and always drive
  behavior
• The first principle is that you must not fool
  yourself and youre the easiest person to fool.
  
• Richard Feynman
• Nobel Laureate Physicist

10
Incentives Drive Behavior

• Look for managements that have a major piece of
  net worth at risk
• Focus risk its very difficult to get even one
  thing right
• Only low cost supplier wins
• Its the EPS, stupid
• Dont forget about the denominator

11
CEOs Report Card

• EPS
• NAV/ Share
• ROBE gt 15

12
The Disclosure Game

• Credibility
• Most valued currency
• Reg FD
• Its a marathon not a sprint
• Hare vs. the tortoise
• Speed at which our success is recognized is not
  important as long as were increasing intrinsic
  value at a satisfactory pace
• I.e., it aint about day to day stock price

13
The Disclosure Game Why Bother?

• Lumpy earnings vs. smooth
• Our earnings are going to be lumpy
• Market prefers smooth
• A lumpy 15 is better than a smooth 10
• No VP investor relations and no quarterly
  conference call
• Perception may be reality in the short-run, but
  in the long-run reality is reality

14
Corporate Governance

• Annual election of Directors
• No loans to employees or directors
• No repricing of options / five year vesting
• No CEO bonus unless profitable.CEO base salary is
  150,000/year
• The Company plane is Southwest Airlines
• Sorry, no charitable giving
• CEO is the only inside director
• Transparent accounting
• Successful efforts accounting for oil gas
  activities
• Mark-to-Market accounting for hedges
• Options are expensed
• BOD management own 58 of fully diluted shares
• Incentives aligned

15
Everything Is Always Uncertain i.e. Risky

• What degree of confidence in the estimated
  distribution of outcomes?
• Avoid Gamblers Ruin
• How much to bet? Invest? Risk?

16
Econophysics 101 - Most Of The Important Stuff Is
Anomalous

• 1 d captures 68.3 of all occurrences
• 2 d captures 95.4 of all occurrences
• 3 d captures 99.7 of all occurrences
• Most of life is lived in 1 d world
• Most really big economic opportunities (and
  losses) are in the 2 d - 3 d world
• To capture the big opportunities, you need
  capital
• Caution In real life the tails are fatter than
  they are in the economic models

17
Econophysics 101 - Log Normal Is Normal

• Many of the most important relationships in oil
  patch and finance are lognormal
• Estimates of reserve sizes
• Net pay x recovery per acre x area
• Nature makes more small fields than giant ones
• Black-Scholes model
• Price percentage changes are assumed to be
  normally distributed
• But future stock prices are log-normally
  distributed ( i.e. prices can go to infinity, but
  cant fall below 0)
• Paretos law
• Wealth distribution, but also applies to oil
  finders
• 10 of geoscientists discover 90 of hydrocarbons.

18
Econophysics 101 - Chain Multiplication Kills

• S Source of hydrocarbons
• T Trap. Hydrocarbons are still there
• R Reservoir capable of producing
• V L x W x H
• POS Probability of success
• POS S x T x R x V
• POS .8 x .8 x .8 x .8 41

19
Conclusion

• By the way, any company worth buying will have
  to pay taxes
• Warren Buffet Bershire Hathway 2002 annual
  meeting
• What to look for in a small cap E P
• Major investment by management and BOD
• Right guys drawing the XYZs
• Bank debt leveraged balance sheet (4 interest
  rate)
• Low cost/Low burn rate
• Accounting transparency Economic reality Cash