Experienced traders and seasoned investors often mention discipline as one of the keys to success in this industry. While some speculation is encouraged, drawing the distinction between ‘the good’ and ‘the bad’ kind can be difficult. A common misconception is that this only applies to ‘investors’ however, corporations face similar dilemmas when deploying their capital. Establishing and adhering to a proper risk/reward balance is key and only if an investments lands in the right spot should the trigger be pulled.
Contango Oil & Gas (MCF) believes it has found one of those opportunities with the recent spinoff of its Contango Ore or “CORE” (CTGO) subsidiary. The spin has mining rights to over 750,000 acres of land in Alaska and will engage in the exploration for gold and rare earth elements. Although preliminary studies merited additional exploration, they did not identify any quantifiable mineral resources. The company has enlisted the Avalon Development Corporation, an Alaskan-based mineral exploration consulting firm, to help with the exploration and geological assessments. The current plan is to fly airborne magnetic, electromagnetic, and radiometrics early next summer in order to determine whether to proceed further. Interestingly, according to CORE’s Form 10 (a must read) the company can only work between May and October due to the harsh climate.
Contango invested a small amount of capital into CORE which will mostly get depleted during the exploration process. CORE has no other existing credit agreements and will be run on a ‘bare bones’ G&A expense budget of less than $100,000/year to best utilize its available capital. Aside from the contractual services provided by Avalon, the company has only 3 part time employees including Ken Peak, the CEO of both Contango and CORE. The other two ‘temps’ are the CFO/secretary and controller. The company solicited a valuation report of CORE’s asset values from Avalon and with the additional $3.5 million cash investment by Contango, the value of the assets contributed to CORE and distributed to Contango shareholders is estimated to be $0.46 per share of Contango or $4.60 per share of CORE.
According to Mr. Peak, the investment was attractive due to ‘its risk/reward’ ratio but it “should be considered as nothing more than an “interesting speculation” and that the odds of our ultimately being successful in finding gold in a volume sufficient to support a commercial gold mining operation are quite low. To put it in oil and gas parlance, this “play” is the rankest of “wildcats” that is currently only at the “idea” stage…” In fact, the final observation of CORE’s recently published investor presentation is that the company is “pure and simple speculation.” Obviously, Mr. Peak is bullish on gold (whose price has risen meteorically) and rare earth elements, the latter of which have been receiving a ton of media attention since the Japan/China fisherman spat. The presentation and initial press release linked to above highlight the rationale for investing in these metals.
So what expertise does Contango have in the exploration for gold and rare earth elements? None, although their consultants surely do. However, the company’s belief is that their strategy listed on page 1 of the aforementioned presentation can apply to all commodity businesses. The company’s core beliefs are:
Our Exploration Strategy:
1.The only competitive advantage in a commodity-based business is to be among the lowest cost producers
2.Virtually all the mining industry’s value creation occurs through the discovery of mineral deposits that can be developed into a commercially viable ore body
3.Value creation per share is the only metric that counts
So why does anybody care about a risky spinoff with a roughly $10m market cap? Much of the interest in this name is based on the involvement of Mr. Peak, who has an excellent reputation and a solid track record. He founded Contango in 1999 by investing his entire life savings ($400K) into the business in order to raise the necessary equity. Quite risky, but it has paid off as the business has since grown into a $900m market cap star with over $150m in revenues under his leadership. Additionally, his prior ‘non-core investments’ (LNG facility, shales & fuel cells) have all been big winners for investors.
CORE has roughly 1.6m shares outstanding and according to the Form 10, the directors and officers will control approximately 22% of that total. Additionally, their contract with Avalon grants them 1.5% of the stock. The company has the ability to (and likely will) grant options to its executives and directors especially considering they are not receiving much in terms of a salary. The company can issue 100K of shares/year which is a sizable amount given the low amount outstanding. Management will be highly motivated to succeed, however there is not much they can do about it at this stage. Either the reserves exist or they don’t.
Considering the tiny size of the spin and the unrelated focus, one would have expected strong selling pressure post spin however, the stock price has since steadily climbed. Considering the company’s value estimate was $4.60/share, the stock appears to be a bit pricey. Then again, this is not your typical spin as there is no operating history to parse through or new synergies to analyze. Perhaps investors desired some exposure to these elements or refrained from indiscriminate selling due to the thinly traded market on the stock.
Much like an option, CORE’s stock price should suffer from time decay as its shelf life is tied to the longevity of its ever diminishing cash balance. I feel that waiting for the price to decline for this reason would be a mistake though. The way to win here is by owning the company when it announces a find – the longer you own it, the better chance you have. That does not mean you cannot wait to pick it up at a better price, especially if work is not being done until May at the earliest. In the end, it is best to recognize that CORE is a lottery ticket although the odds here are probably better than the 1:176 million which the MegaMillions boast. Take a look at Molycorp (MCP) for an example of the potential rewards of finding rare earths (although note there is a big step between finding them and mining them). You own this as a pure and unadulterated speculative play and a vote of confidence in Mr. Peak’s risk/reward analysis. If that doesn’t sound attractive to you or seems like undisciplined investing then I would pass.
Disclosure: Author holds no position in any stock mentioned
