Contango Oil & Gas Company
Q2 2021 Earnings Call Transcript

Published: 11 Aug 2021

[Operator:]

Good day, and welcome to the Contango Second Quarter 2021 Results Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Wilkie Colyer. Please go ahead.

[Wilkie Colyer:]

Thanks, Melissa. Good afternoon, and thank you for joining us for our second quarter 2021 earnings conference call. I'm Wilkie Colyer, Chief Executive Officer of Contango. Joining me this afternoon on the call are John Goff, our Chairman of the Board; Farley Dakan, our President; Chad Roller, our Chief Operating Officer; Joe Grady, our Chief Financial Officer; and Chad McLawhorn, our General Counsel. Hopefully, everyone has had an opportunity to read through this afternoon's press release, including the cautionary statements regarding forward-looking information and non-GAAP measures that apply to the statements on this call. Also, I will make reference to a presentation posted to our website today called Q2 2021 Update. So please pull that up if you would like to follow along. I'll now pass the call over to John Goff for his opening remarks.

[John Goff:]

Thank you, Wilkie, and good afternoon, everyone. We very much appreciate you joining the call. Before Wilkie covers the quarter and the merger update, I want to cover some important points that guided my thinking as Chairman and as the largest shareholder of the company, and making the decision to merge with Independence. Having been an investor for a long time in the public markets, serving as CEO of a public company for many years, I'm always intrigued with the market's reaction to big news. Our announcement of the merger with -- the merger with Independence is an excellent case study. Post announcement, our shares have underperformed our market comps when, in my mind, and even mathematically, we should have outperformed. I have no doubt that, that will change with time as the merits of the deal come to light. We dumped a lot of information on the market, when we announced the merger, and it clearly takes time for investors to absorb and fully understand the impact of the transaction. Couple that with little analyst coverage, something that we're definitely going to rectify post-merger, and we intend to do that, and we'll begin work on that soon, I want to reiterate why we worked hard to make this happen as a company, why we were collectively supportive as a Board, as well as a management team, and why I am personally 100% behind it. It's no secret I have a passion for building businesses. Crescent Real Estate started on my desk with a yellow pad in the early '90s, ultimately became a New York Stock Exchange-listed company. It grew over 13 years until its sale at $6.5 billion to Morgan Stanley in 2007. My initial investment thesis for Contango 3 years ago was to use this company as a platform to consolidate oil and gas assets during a low point in the energy cycle. Very comparable to what we did in the real estate industry in the early to mid-90s. After cleaning up the business, Wilkie and team have done a terrific job of executing on very attractive acquisitions and significantly growing the business. I have said many times, even prior to this announcement, that Contango can and will be much larger than Crescent ever was. I believe that statement even more today than when we made the initial investment 3 years ago. In that 3 years, the industry has changed and the acquisition opportunities are evolving. I want to make 4 key points

[Wilkie Colyer:]

Thanks, John. I'd like to start with a quick overview of the quarter for Contango, and then move on to a discussion of recent strategic initiatives we've entered into. On the quarter, we accelerated workover spending, particularly on our 2 recent acquisitions into a strengthening crude price environment. Result was production coming in above guidance on LOE spending that was also slightly above guidance. The bottom line for the quarter is that we were able to increase daily production by over 12% in Q2, relative to the February and March daily average, and I'm using February and March because that was post the closing of the 2 acquisitions we've made. It's important to point out that we achieved that 12% production growth while paying down debt by approximately $30 million in Q2 alone. We believe this demonstrates the optionality and the free cash flow inherent in our low decline portfolio, and it demonstrates an ability to react quickly to changes in crude prices, both positive and negative. Moving to strategic initiatives. We have made 2 major announcements since our last quarterly call. The first is our announced merger with Independence Energy, which will create an industry-leading consolidator with a market cap and an enterprise value of $3 billion and $3.8 billion, respectively, based on market prices as of August 6. The second is our acquisition of ConocoPhillips, Wind River Basin assets, which we were able to buy at an attractive price with the potential to further enhance long-term value through cost savings initiatives we have identified during our due diligence process. Let's cover the Independence merger first. The process, which culminated in a merger announcement with Independence really started back in January. It was the Contango Board and management's view that a bifurcation was forming in the market between the haves and have-nots based on several factors, with the most important one being size and scale. We would characterize the haves as companies that are not reliant on bank capital or the RBL market for growth. In our view, banks have backed away from the market, because of a combination of prior losses and ESG and investor pressures. There seems to be a correlation between those 2, but that could be a coincidence. Regardless of the rationale, the job of a commercial lender in the upstream space is a tough, tough job to have right now. We witnessed firsthand just how difficult the market is for attracting bank capital when we increased our borrowing base in Q2. While we were successful in that endeavor and are deeply grateful to our lending group for supporting the large increase, it was clear that future increases would get incrementally more difficult. So as a Board and management, we were staring at an enormous market opportunity, where we expect billions of dollars of PDP-heavy assets to trade hands over the next few years into a market with fewer and fewer well capitalized buyers. We needed to get bigger to execute on this next wave of opportunities. When discussions with Independence began to heat up, we analyzed the opportunity by asking a few simple but very important questions. First, do we expect the deal to increase intrinsic value per share for our shareholders? As discussed previously and shown on Slide 23, this transaction is accretive to Contango cash flow per share by 50% in 2022, our expected first full year of combined operations. As John said, we have never seen a deal before with that level of accretion to existing shareholders. Second, will this transaction be designed to drive down costs, particularly G&A and cost of capital relative to Contango stand-alone? The answer is absolutely. Let's start by discussing pro forma G&A. Turning to Slide 7 of the presentation. The first thing I would point out is that the $5 million negotiated fee paid to KKR, associated with the addition of Contango assets to the combined company, pays for a suite of services per our management services agreement. It covers a broad scope of typical G&A items quite efficiently. KKR will be paying the compensation of all the executives shown on Slide 6, as an example, and we also benefit from the broader KKR resources such as global macro, public affairs, KKR Capital Markets, the KKR Global Institute, and the client and partner group, not to mention their access to capital and global reputation. When you combine all the overhead of the business, including fees, both at the corporate and sub level, for example, Contango's G&A, and look at it relative to peers, both as a percentage of EV and a percentage of EBITDA and graphical depiction of that are on the right side of Slide 7, two things stick out. The first is that the combination makes us more efficient as a company relative to Contango standalone. The second is that we screen very well relative to our mid-cap peers in both of those metrics. Efficiency is critically important in these commodity businesses, particularly when capital is scarce and at a cyclical low, and we will continue to drive down our cost structure in this platform as we scale. On cost of capital, let's turn to Slide 18. The combined business will have investment-grade credit metrics, and we expect will ultimately have an investment-grade rating longer-term as the business continues to scale in a disciplined way. This competitive advantage cannot be overstated. The opportunity to potentially fund the business at a differentiated cost of capital will be a huge advantage relative to our peers, who we think have cost of capital in the high teens, if not higher. We will also maintain a low leverage profile with a long-term leverage target of approximately 1x debt-to-EBITDA. Third, since we are seeding control, are we like-minded in our pursuit of value with the new leadership team of the combined business? The first thing I would point out in considering this question is back on Slide 6, which shows that we will continue to be peer-leading in terms of insider ownership post this transaction. KKR has a substantial on-balance-sheet investment in Independence, and we still find that the best way to align incentives in business is for management to have skin in the game. Of course, the Chairman of the Board of the combined business, John Goff, will maintain a very large position in the stock personally. The next thing I would highlight around alignment is on Slide 13. Bottom left quadrant. You'll notice that in 2020 and 2021, both Contango and Independence were able to put capital to work countercyclically. And as importantly, at a time when a lot of Contango's peers in the public market and Independence's peers in the asset management space, waited on the sidelines. On that note and turning to the next slide, Slide 14. On a combined basis, we have put $850 million of capital to work in 2021 alone on proven, cash flowing assets with meaningful upside. And just to clarify, the Mid-Con Energy Partners and Silvertip deals closed in 2021, but were signed in late 2020. So those are included here as 2021 events, because that's when they closed. I would also note that at the time of the signings, the weighted average spot oil and gas prices for this $850 million of capital investment was $45.27 per barrel and $3.01 per Mcf, respectively. So we feel -- so we think these purchases were highly opportunistic. This also sets us up well to capitalize on future market opportunities, since we both have a reputation of finding differentiated risk return opportunities and being able to get things done. Last, are we positioned to do a better job for our shareholders in this broader, more scaled platform? Our view is that we can expand our successful acquisition program to include larger deals, we previously couldn't capitalize on as a stand-alone smaller company. To sum it up, the answer to all 4 questions we asked made Independence a perfect fit for Contango. We believe this combination creates a business with investment-grade credit metrics, a diversified asset base and commodity mix, better access to capital, both debt and equity, and a competitive advantage over other consolidators via a substantial size advantage. We look forward to working with David and his team at KKR to continue growing via acquisition for the benefit of all stakeholders. For more information on the proposed merger, there is an S4 filed with the SEC under the company name IE PubCo, Inc. that stands for Independence Energy PubCo, Inc., so IE PubCo, Inc. Next, we thought it would be helpful to add some context to the market opportunity by providing some additional color on our most recent acquisition of the Wind River assets from ConocoPhillips. See Slide 15. This acquisition checked a lot of the attribution boxes we look for when evaluating new opportunities. Asset quality and profile. This is a world-class conventional gas deal that has recovered 2.8 Tcf to date. It's a low-decline asset with a long reserve life. 78 million cubic feet equivalent per day of net production currently and on an expected 5% decline. Vertically integrated asset provides the opportunity to maximize margins. It's an attractive risk return profile. We acquired these producing reserves in an attractive stand-alone rate of return and kept all further upside for Contango's benefit. And a quick payback period and attractive long-term exposure to natural gas prices and operational improvements were also an attraction. Future value creation opportunities. We think there are multiple opportunities inherent in the asset to reduce costs and improve profitability and cash flow to create meaningful incremental long-term value on the asset. And it also enhances our existing operational footprint. This is Contango's third acquisition of conventional assets in Wyoming, and we intend to be on the lookout for more. We like the Wyoming area, like the Wyoming State and the Rockies' conventional asset profile. The Wind River Basin acquisition is expected to increase Contango's total run rate production by approximately 57% in Q3 of 2021. We think that our experience in the area, reputation in the market, and clean balance sheet were as important, if not more important, than purchase price for a company like Conoco, who is looking for a clean break as a top priority when divesting of assets. We think Contango, particularly as a subsidiary of an even larger business post the Independence merger, will be a very attractive partner for larger enterprises looking to divest assets that are later in life, and we certainly plan on capitalizing on those opportunities. I'll finish up my prepared remarks with a discussion of the acquisition pipeline. We are finding that there is certainly more interest in upstream oil and gas assets than there was late last year or early this year. Consistently, we understand that there are more CAs signed, more management presentations and more bidders involved in marketed processes. What we are less sure about is what percentage of those bids are real and what percentage of those bidders actually have the capital to close. For us, we will stick to our disciplined underwriting standards and let the chips fall where they may. We have the benefit of a diversified set of assets that creates durable cash flow and have no need to chase deals to "get in business", which we see a lot of teams without assets doing right now. Over time, we think the pipeline of deals could ultimately outstrip the capital available in the industry, particularly on the conventional side. With that backdrop, we expect to have a healthy pipeline of attractive opportunities to prosecute for the next few years. Thanks again for your time this afternoon and for your interest in Contango. With that, operator, let's open up the line for questions.

[Operator:]

And we will go ahead with our first question.

[Unidentified Analyst:]

Wilkie, it's Andy Capital. I saw Chesapeake announced recently a -- this kind of variable dividend concept in which they're targeting a much higher amount of free cash flow to be paid out quarterly. I think they're targeting 50% of free cash flow. And I note that you guys are targeting about 10% of EBITDA. How do you think about the dividend trade-off versus redeploying cash flow and acquisitions?

[Wilkie Colyer:]

Yes. It's a good question. I'd start off by saying just using rough math. If we're talking 10% of EBITDA, and we're spending about 50% of EBITDA in CapEx, then you're really talking about 20% of free cash flow, right? So look, we -- this is probably a better question for David and his team and John with Independence, since they will be leading the new co. But I know from knowing those guys that they view dividend as good discipline and good risk mitigation. And so that dividend profile gives us the ability to maintain that discipline, but also grow the business at a time that we think it's very attractive to do so. So I think that will be really driven by John and then the management team of the new co ultimately. But John, anything you want to add there?

[John Goff:]

No, I think that's right. We'll wrap our heads around that as we get closer to the merger exactly what the policy is going to be, but we laid that out as just a broad kind of scope dividend. I think the way I personally traditionally looked at this as always measuring the value of that dividend versus the value of an acquisition versus even the value of buying stock back. So I think all those will be weighed against each other at the appropriate time.

[Farley Dakan:]

I personally think that back to the point about having access to capital via this merger, we don't feel like we are going to be disadvantaged to take advantage of opportunities just because we've instituted a dividend. We think that we'll have access to capital, up and down the capital structure, should we find accretive opportunities to embark upon.

[Wilkie Colyer:]

But no question that the scale of this combined business is really what certainly gives Independence the confidence to institute the dividend, whereas with Contango stand-alone, I think we're super focused on growth and reinvesting all those dollars, because we didn't want to let them out of the system.

[Unidentified Analyst:]

I just -- the thing is, right, when you get to these levels of cash flow on an operating basis, that this entity should be capable of generating the stock would be much, much higher if the dividend was higher than what you guys are currently advertising. And so I think you guys need to think about articulating a strategy around why it's more beneficial to redeploy the free cash flow into CapEx and acquisitions than it is to distribute it to shareholders. Because I think that's part of the confusion with the story here as to why the stock suffers. So I think Chesapeake's announcement of 50% of free cash flow and obviously, whatever they're doing and they're delevered and coming out of a restructuring, et cetera. So it's a slightly different business, but that's something that I think you guys should just give some thought to as you merge this thing up and think about maybe how to address that in the quarterly calls in the future.

[John Goff:]

Yes. I think it's a valid point.

[Wilkie Colyer:]

Yes, I agree with that, Andy, and appreciate the color from your side. And I know that the new co Board will take that into account.

[Operator:]

[Wilkie Colyer:]

All right. Well, seeing that there are no other questions, we'll go ahead and sign off. We appreciate everybody's time today and everybody's interest in Contango. Like John said earlier, to the extent folks have follow-up questions, please don't hesitate to reach out to us. We're happy to answer those. And again, appreciate everybody's time. Hope you have a great rest of your day. Thanks.

[Operator:]

This concludes today's call. Thank you for your participation. You may now disconnect at this time.