Investing is a game where the longer you play the better you become. There is no doubt about that. There is no way that you don’t become a better investor by learning from your own mistakes. The key is to not lose too much of your capital as you build up this knowledge base.
A couple of years ago Charlie Munger referred to Buffett being a much better investor in his late 70s than he was 20 years prior. Munger called Buffett a “learning machine”. I’m not saying we can all be successful like Buffett because most of us are of average intelligence, but we can become much better investors by managing our capital carefully and realizing that “we don’t know what we don’t know”.
As I learn painfully from my own mistakes I also try and learn from both the success or failure of others. One investor that I find particularly interesting is Mark Sellers who used to run a hedge fund which was very successful for most of the last decade. At one point he had almost all of his fund in one stock (Contango Oil and Gas) which was a tremendous success for him. As I study his thinking in making such a big bet on Contango I find myself wondering if it was truly the act of an intelligent investor or a case of someone with less than a decade of managing money being overconfident.
I’ll discuss this later, but first read some excerpts below from a Sellers Capital presentation at a Value Investing Conference in 2007. It provides the thinking behind Sellers Capital approach as well as the specific thinking regarding the Contango investment.
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: 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 all 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
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.
I like all of the thinking both in Sellers approach to investing and in the idea that the market pays nothing for optionality. The Contango investment worked out incredibly well for him, and was an excellent example of investing with an eye to minimizing potential loss of capital.
However, I have to note one thing and that is that Sellers was DEAD WRONG on natural gas. His investment thesis was that natural gas could not stay below $6 for an extended period of time because production would be shut in as it was uneconomic to produce at prices under $6. Where are we at today, almost two years into natural gas prices ranging from $2.50 to $6 ?
Based on what Sellers knew about natural gas fundamentals I think his conclusions are fine. But what you always have to remember is that “you don’t know what you don’t know”. What he didn’t know was that on top of the Barnett Shale and the Fayetteville Shale would come the Haynesville and the Marcellus. The natural gas supply picture has changed. And that dramatically changes the value of Contango.
He took on what I think is an absurd amount of risk by putting as much of his fund into Contango as he did. What if Contango had been involved in some sort of BP type accident that subjected it to billions of dollars of damages ? I think taking that type of risk is done by someone who hasn’t been through a 2008 type of panic where the world goes sideways and the unimaginable occurs.
So for me from this presentation, I take away many, many useful lessons from Sellers the intelligent investor. Minimize downside risk, hold your capital until the odds are in your favor, look for free options that the market is assigning no value to. I like everything about his approach to investing other than his position sizing. I’m willing to bet big, but not so big that if I have made a mistake I’m not going to be ruined by it.
A couple of years ago Charlie Munger referred to Buffett being a much better investor in his late 70s than he was 20 years prior. Munger called Buffett a “learning machine”. I’m not saying we can all be successful like Buffett because most of us are of average intelligence, but we can become much better investors by managing our capital carefully and realizing that “we don’t know what we don’t know”.
As I learn painfully from my own mistakes I also try and learn from both the success or failure of others. One investor that I find particularly interesting is Mark Sellers who used to run a hedge fund which was very successful for most of the last decade. At one point he had almost all of his fund in one stock (Contango Oil and Gas) which was a tremendous success for him. As I study his thinking in making such a big bet on Contango I find myself wondering if it was truly the act of an intelligent investor or a case of someone with less than a decade of managing money being overconfident.
I’ll discuss this later, but first read some excerpts below from a Sellers Capital presentation at a Value Investing Conference in 2007. It provides the thinking behind Sellers Capital approach as well as the specific thinking regarding the Contango investment.
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: 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 all 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
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.
I like all of the thinking both in Sellers approach to investing and in the idea that the market pays nothing for optionality. The Contango investment worked out incredibly well for him, and was an excellent example of investing with an eye to minimizing potential loss of capital.
However, I have to note one thing and that is that Sellers was DEAD WRONG on natural gas. His investment thesis was that natural gas could not stay below $6 for an extended period of time because production would be shut in as it was uneconomic to produce at prices under $6. Where are we at today, almost two years into natural gas prices ranging from $2.50 to $6 ?
Based on what Sellers knew about natural gas fundamentals I think his conclusions are fine. But what you always have to remember is that “you don’t know what you don’t know”. What he didn’t know was that on top of the Barnett Shale and the Fayetteville Shale would come the Haynesville and the Marcellus. The natural gas supply picture has changed. And that dramatically changes the value of Contango.
He took on what I think is an absurd amount of risk by putting as much of his fund into Contango as he did. What if Contango had been involved in some sort of BP type accident that subjected it to billions of dollars of damages ? I think taking that type of risk is done by someone who hasn’t been through a 2008 type of panic where the world goes sideways and the unimaginable occurs.
So for me from this presentation, I take away many, many useful lessons from Sellers the intelligent investor. Minimize downside risk, hold your capital until the odds are in your favor, look for free options that the market is assigning no value to. I like everything about his approach to investing other than his position sizing. I’m willing to bet big, but not so big that if I have made a mistake I’m not going to be ruined by it.
