This Little-Known Oil Stock Quietly Completed One of the Best Acquisitions of 2016

By Matthew DiLallo Markets Fool.com

Contango Oil & Gas (NYSEMKT: MCF) wasn't on the radar of most investors at the start of last year. However, after gaining 46% in 2016 and completing one of the best acquisitions of the year, the stock should be one that energy investors take a closer look at this year. That's because that deal provides it with a very attractive entry into one of the hottest oil plays in the country, which could fuel explosive growth for Contango in the years ahead.

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The quiet transition

Like many oil and gas companies, Contango Oil & Gas entered 2016 in a bit of a bind. Crashing commodity prices forced the company to cut back on drilling and focus on strengthening its balance sheet. While the company had amassed a portfolio of exciting development opportunities, it decided not to commence any development programs until commodity prices recovered. As a result, CEO Allan Keel said that Contango would "limit our 2016 capital program to very limited drilling and certain lease extensions, and repaying amounts outstanding under our revolver," which stood at $115.4 million under its $190 million borrowing base.

Image source: Getty Images.

However, Contango came across an opportunity to acquire acreage in the Permian Basin that it just could not pass up. In July the company entered an agreement to purchase a one-half interest in 5,000 net acres in the Delaware Basin for up to $25 million. The deal price implied a per acre value of roughly $10,000 for land that offset Concho Resources(NYSE: CXO) and Brigham Exploration. This offset position is noteworthy because Conoco Resources paid more than $30,000 per acre for land in the region earlier in the year and would go on to pay more than $26,000 per acre for land a few months after Contango's purchase. Meanwhile, Brigham Exploration just sold itself to Diamondback Energy (NASDAQ: FANG) for $2.43 billion, implying a per acre price of around $32,000. In fact, Contango's deal was among the cheapest in the basin last year. Only EOG Resources' (NYSE: EOG) acquisition of Yates, at an implied per-acre value of around $7,500 according to analysts and a couple of deals by Parsley Energy (NYSE: PE) for around $10,000 per acre, were lower.

In conjunction with its acquisition, Contango would complete a $50.5 million equity offering. That would give the company enough cash to fund the deal's $10 million closing cost, its $10 million drilling commitment, as well as provide it with money to pay down debt. In fact, as a result of that offering, and its ability to generate excess cash flow during the year, the company whittled down its debt balance to $62.5 million by the end of the third quarter.

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Ready to launch

Since closing that transaction, Contango and its partner would go on to increase their footprint in the region so that the company now controls 6,250 net acres, which hold an estimated 200 future drilling locations. Further, the partners have already started drilling an initial set of four wells. They plan to complete these wells in a sequence this spring, take a pause to access their performance, and then get to work on another set of five wells in July. This measured approach will enable Contango to limit its spending to internally generated cash flow for now while it optimizes its drilling process. However, should the wells exceed expectations, or commodity prices rebound sharply, the company has the financial flexibility to ramp spending and drill more wells, which is a catalyst that could catapult the stock this year.

Image source: Getty Images.

Contango believes it's sitting on a very valuable position that it acquired for a fraction of the price rivals are paying for land. CEO Allan Keel recently noted that,

There have also been a number of recently announced asset transactions nearby at prices in the range of $30,000 per undeveloped acre, after adjusting for production, that make us optimistic about the inherent value of our position. We believe that our current acreage position in the Delaware has the potential to be very impactful for our shareholders.

One reason producers are willing to pay such high prices is that these acreage positions are fueling transformational production growth for the acquiring companies. For example, Diamondback Energy sees its output jumping 60% this year due in part to Brigham's current production as well as growth from drilling more high-return wells. Meanwhile, Parsley Energy sees its recent M&A binge across the basin fueling a nearly 100% increase in its production rate by the end of this year compared to where it ended 2016. Further, even large-cap producers like Conoco Resources and EOG Resource expect to deliver double-digit oil production growth over the next several years at current commodity prices thanks to their lucrative Permian positions. These growth rates suggest that Contango, likewise, could generate remarkable production increases once it starts developing its position.

Investor takeaway

Contango Oil & Gas' entrance into the Delaware Basin is not expected to fuel much production growth this year because it is still testing the acreage. However, once it collects more data and can determine the best way to develop this land, it could provide the company with a high-return growth opportunity to fuel production growth for years to come.

That said, in the near-term, the company still has plenty of catalysts that could drive the stock higher, including the release of well data on its initial set and a possible upward revision to its capital plan that could detail a clear path for production growth. If Contango's position in the Delaware is as good as it thinks, the market could reward this stock with a much higher value in the future.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of EOG Resources. The Motley Fool has a disclosure policy.