Q2 2021 Contango Oil & Gas Co (Texas) Earnings Call

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Good day and welcome to the Contango second quarter 'twenty 'twenty. One 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.

Thanks Melissa.

Good afternoon, and thank you for joining us for our second quarter 2021 earnings Conference call.

Wilkie Colyer, Chief Executive Officer of Contango joining me. This afternoon on the call are John Goff, our chairman of the board.

We've taken 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 Golf for his opening remarks.

Thank you Wilkie and good afternoon, everyone. We very much appreciate you joining the call.

Before we'll keep covers the quarter in 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 independents.

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.

The announcement of the merger within the <unk>.

Excuse me with the merger with Independents is a 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 Cup.

Couple that with little analyst coverage, something that we're definitely going to rectify post merger.

And we intend to do that and will begin work on that soon.

I want to reiterate why we worked hard to make this happen as a company while we work collectively supportive as a board as well as the management team and why I am personally 100% behind.

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 nineties ultimately became a New York Stock Exchange listed company grew over 13 years until its sale at six 5 billion to Morgan Stanley in 2007.

My initial investment thesis for contango three years ago.

Was to use this company as a platform to consolidate oil and gas assets during a low point in the energy cycle.

Comparable to what we did on the real estate industry in the early to mid nineties.

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 <unk> ever was I.

I believe that statement, even more today than when we made the initial investment three years ago.

Yeah.

And that three years, the industry has changed and the acquisition opportunities are evolving I Wanna make four key points number one.

Traditional bank lending to the energy sector is a much less reliable capital source than in the recent past it clearly should not be part of a long term capital plan.

Equity in the unsecured debt markets are now more critical than ever having an investment grade credit rating will be the differentiator in the future, allowing for the lower lowest cost of capital.

The merger with independence gives us that.

Number two.

As always we feel strongly that to be successful in the long term, we must have a durable capital structure that can withstand any volatility volatility of the markets, both the commodity markets as well as the capital markets.

That means we need to maintain low leverage and have inexpensive leverage.

We target one times EBITDA as a maximum for leverage on a long term basis, and we want to maintain and generate substantial free cash flow.

The merger with independence insurers this.

Number three.

There remains far too much cost and overhead in this sector and we have a team that is excellent at reducing costs Cigna.

Significantly impacting the positive results, we achieve from acquisitions.

Now that we have proven this to ourselves and to the markets. It broadens our scope of acquisition targets. We will continue to capitalize on this with our merger with independents.

Number four.

I get asked this all the time.

Acquisition opportunities today are as plentiful as they ever have been they are bigger and require greater access to capital. So again scale and cost of capital are critical.

The merger with independence gives us that.

Do not make the assumption that the merger was done because we have run out of opportunities.

You will be making a presumptive mistake.

This merger is being done because of the opportunity set has grown not shrunk.

The opportunity set has grown not shrunk.

Now.

Let me cover several important.

What I think are critical things that I think the market is missing misunderstanding or misinterpreting number one accrete.

Accretion of the deal this transaction the merger with independents is 50% accretive to contango shareholders. In 2022, our first full year of operations. After closing it is 50% accretive I've been in the business a long time I have never seen.

Deal a merger that was 50% accretive much less ever worked on one that is extraordinary.

I don't understand how that's being missed so a dollar of cash flow for a contango shareholder becomes $1.50 as a result of the merger.

Number two.

I hear the comment we are selling out to KKR nothing could be further from the truth I have known Henry Kravis for years as well as much of the KKR management team I've done business with them on a variety of investments in the past all successful we have spent substantial time with the independents team David rocker.

Harley and the rest of the team.

And we have a great deal of respect for them, we see eye to eye on the opportunity in front of us as well as the strategy on how to achieve that and this is going to be a collaborative effort.

I did not ask to be chairman of the New company. They asked me I want to be I want to be chairman. This is fun I love doing this and let me be clear I'm, not receiving any fees or any payments outside of the traditional directors' compensation.

And I don't wake up in the morning thinking about my directors compensation believe me I think about the roughly 50 million shares of stock on them.

And I think about that every day.

Number three KKR will hold a substantial portion of their stock on balance sheet and they have no intention of selling.

I have no intention of selling.

We are both in this for the long term.

This is the singular vehicle that KKR and myself will be using to grow our exposure to the energy sector number four.

Don't be confused by the management fee the management fee is simply G&A with a different label.

Our collective cost to run this business factoring in the management fee will be among the lowest in our peer group.

Factoring in the management fee the management fee is nothing else in G&A.

We'll keep we'll cover that on a slide and give you some detail.

So in summary, if you want exposure to the necessary and inevitable industry consolidation.

Through a well capitalized company aligned and highly talented and incentivize management team substantial insider ownership with a low cost of capital wonderful free cash flow than we were a great name to consider.

I encourage investors to look at the facts not the rhetoric I've never made a nickel off a blog post.

And call US if you have questions.

We absolutely respect your questions we value your input and we'd love to hear from you. If there's anything that comes up that's confusing to you.

Let me close by reiterating that I'm enjoying being a part of transforming this company and standby my personal target that I've laid out to the team of being a $10 billion plus coming company in the not too distant future I truly think we're going to get there and this is this merger is a huge step in that direction.

Wilkie.

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 on our two recent acquisitions into our strengthening crude price environment.

With production coming in above guidance on Eloise 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 two acquisitions we've made.

It is important to point out that we achieve 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 LOE declined 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 two major announcements since our last quarterly call.

The first is our announced merger with independents 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 six.

Second is our acquisition of Conoco Phillips Wind River basin assets, which we were able to buy in an attractive price with the potential to further enhance long term value through cost savings cost savings initiatives, we have identified during our due diligence process.

Let's cover the independents merger first.

The process, which culminated in our merger announcement with independents really started back in January.

Does 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 ones being size and scale.

We would characterize as the haves as companies that are not reliant on bank capital or the army all market for growth.

In our view banks have backed away from the market because of a combination of prior losses in ESG and investor pressures there.

There seems to be a correlation between those two 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.

We needed to get bigger to execute on this next wave of opportunities.

When discussions with independents began to heat up.

We analyze 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 are for 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 standalone.

The answer is absolutely.

Let's start by discussing pro forma G&A.

Turning to slide seven 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 six 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 pardon.

Her 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 is G&A and look at it relative to peers.

But as a percentage of BV and a percentage of EBITDA and graphical depiction of that are on the right side of slide seven two.

Two things stick out.

The first is that the combination makes us more efficient as a company relative to contango stand alone.

The second is that we screen very well relative to our mid cap peers in both of those metrics.

Patiency is critically important in these commodity businesses, particularly when capital is scarce and at a cyclical LOE and we will continue to drive down our cost structure and this platform as we scale.

On cost of capital, let's turn to slide 18.

Yes.

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 one times debt to EBITDA.

Third since we are ceding 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 when considering this question is back on slide six.

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 and business as for management to have skin in the game.

Of course, the chairman of the board of the combined business, John Golf 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 in 2020 one.

Both contango and independents, we're able to put capital to work counter cyclically and as importantly at a time when a lot of contango as peers in the public market and independence as peers in the asset management space.

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 in silvertip deals closed in 2021.

But were signed in late 2020. So those are included here as 2021 events because that's when they close.

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 <unk> per Mcf, respectively. So we feel so we think these.

<unk>, we're highly opportunistic.

This also sets us up well to capitalize on future market opportunities.

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 standalone smaller company.

Sum it up the answer to all four 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 S. Four filed with the SEC under the company name I E Pub Co Inc.

<unk> stands for an independent energy pubco eight so I E pub Co 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 to eight tcf to date.

It's a low decline asset with a long reserve lives 78 million cubic feet equivalent per day of net production currently and an unexpected 5% decline.

Vertically integrated asset provides the opportunity to maximize margins.

It's an attractive risk return profile.

We acquired these producing reserves and an attractive standalone rate of return and kept all further upside for contango 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 cost 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 is third acquisition of conventional assets in Wyoming.

And we intend to be on the lookout for more we liked the Wyoming area like the Wyoming state and the Rockies conventional.

You know asset profile.

Wind River Basin acquisition is expected to increase contango as 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, where as important if not more important than purchase price for a company like Conoco, who is looking for a clean break is 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 early this year.

Consistently we understand that there are more CA signed more management presentations and more bidders involved in marketed processes.

What we are less sure about is what percentage of those beds are real and what percentage of those bidders actually you 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 quote 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 outstripped 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.

Absolutely.

If you would like to ask a question. Please signal by pressing star one on your telephone keypad. If you were using a speaker phone. Please make sure. Your mute function is turned off to allow your signal to retire Clinton.

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Please state your name before posing your question.

Again press Star one to ask a question, we'll pause for just a moment to allow everyone an opportunity to signal.

And we will go ahead with our first question.

Caller you May go ahead your line is live.

He will get the anti genic Clinton's capital how are you.

Yeah, how are you Andy I'm good good.

Chesapeake announced recently a.

Just kind of variable dividend concept in which they're targeting a much higher amount of free cash flow to be paid out quarterly.

You'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 tradeoff versus redeploying cash flow and acquisitions.

Yeah.

Yes, it's a good question.

Set up by saying that 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.

Yeah, 20% of free cash flow right. So yeah.

Yeah.

This is probably a better question for David and his team and John.

You know it with independents since they will be leading the newco, but I note from knowing those guys and that they.

View dividend is good 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 is very attractive to do so so.

So you know I think that'll be really driven by John and then the management team of <unk>.

The newco ultimately, but John anything you want to add there.

No I think thats right.

We will.

Wrap our heads around that as we get closer to the merger exactly what the policy is going to be but we 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 you know.

I think all of those will be weighed against each other at the appropriate time.

Yes. This is Farley area.

I personally think that back to the point about you know having access to capital via this merger.

No. We don't feel like we are going to be disadvantaged to take advantage of opportunities just because we've instituted a dividend you know we think that will have access to capital.

Up and down the capital structure should.

Should we find accretive opportunities to to embark bonds, but no question that the scale of this combined business is really what you know certainly gives independence that confidence to institute the dividend, whereas you know with contango stand alone I think we were you know.

Super focused on on <unk>.

Gross and reinvesting all of those dollars because we you know we.

Didn't want to let them out of the system.

Yes, I got it I just you know the thing is right. When you get to these levels of cash flow on a on an operating basis that we should be capable of generating.

The stock would be much much higher if the dividend was higher than what you guys are currently advertising. So I think you guys need to think about articulating a strategy around why it's more beneficial to redeploy the free cash flow and the Capex and acquisitions and it is distributed to shareholders. Because I think that's part of the confusion with the story here as to what the stock suffers.

So I think you know Chesapeake announcement of 50% of free cash flow and obviously whatever they are doing in their de levered and coming out of a restructuring et cetera. So it's a slightly different business, but that's something that I think you guys had this.

Give some thought to as you merge this thing up and <unk>.

About maybe how to address that in our in our quarterly calls in the future.

Yes, I think its valid point, yes, I agree with that Andy and I appreciate the color from your side.

I know that the.

Newco Board will will take that take that into account.

Thanks, guys.

Thanks, Andy.

And as a reminder to our audience. If you would like to ask a question you may signal by pressing star one on your telephone keypad.

Okay.

Alright, well seeing that there are no. Other questions. We'll go ahead and sign up 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 in.

Yeah again I appreciate everybody's time hope you have a great rest of your day.

Yeah.

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

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