Contango Oil

1
Contango Oil Gas

• The following presentation was given by Ken
  Peak, Chairman and CEO of Contango Oil Gas, to
  Geology, Physics, and MBA students of Ohio
  University on October 5, 2001.

2
Natural Gas Oil Exploration Business

• Its a challenging 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
Breaking Up Is So Easy To Do

• 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
• Our real competition is coal, nuclear, Canada,
  and surplus capital

4
Value Creation/ Destruction

• What does Contango do to create value?
• Find and develop natural gas and oil at an
  economically attractive price 1.00/mcfe is
  our goal
• What can happen to destroy value?
• Drill a bunch of dry holes
• Run out of money
• Have too much debt
• Big drop in natural gas prices NOT!
• Murphy

5
Before You Graduate, Learn A Little

• Accounting/ Finance
• Statistics/ Probability
• Human Psychology

6
How And What You Count Counts

• Accounting book value bears only a coincidental
  relationship to intrinsic value
• Full cost vs. successful efforts
• Never let accounting consequences influence a
  decision

7
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 will shareholders get for this expenditure?
• Clues to whats in the black box
• Macro environment
• Industry environment
• Managements integrity
• Managements incentives
• Managements track record

8
Human Behavior 101

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

9
Incentives Drive Behavior

• Have a major piece of net worth at risk
• Focus risk
• Only low cost supplier wins
• Its the EPS, stupid
• What gets measured, gets managed

10
CEOs Report Card

• EPS
• NAV/ Share
• ROACE gt 15 for now

11
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

12
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

13
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?

14
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 economics 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

15
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.

16
Econophysics 101 - Chain Multiplication Kills

• S Source of hydrocarbons
• T Trap. Hydrocarbons are still there
• R Reservoir capable of producing
• E Economic success vs. geologic success
• POS Probability of success
• POS S x T x R x E
• POS .8 x .8 x .8 x .5 26

17
Econophysics 101 Are Markets Random Walks?

• Geometric brownian motion (Einstein 1905)
• Standard deviation or volatility ( d is proxy for
  risk)
• d scales to square root of ?T
• Natural gas contract has volatility of 72
• Daily volatility .72 square root of 256
  trading days .045
• 2.00 natural gas 1 d 1.91 - 2.09 2 out of
  every 3 days
• 2 d 1.82 - 2.18 1 out of every 20 days

18
Econophysics 101 - What Would I Do My
Dissertation On

• Fractal market analysis
• Edgar Peters has written a superb book
• Rejects Gaussian hypothesis that markets are
  random walks with a 50/50 chance of rising or
  falling.
• The frequency distribution of returns for the 103
  year history of DJIA is not normally distributed
• Information is valued according to Investment
  Horizon
• Day trader technical
• L/T investors - fundamental
• Markets are Hurst processes exhibit trends
  until an abrupt and discontinuous change
• Reconciles randomness and persistence, so
  evident in markets