| CONTANGO OIL & GAS CO Item 1A Risk Factors In addition to the other information set forth elsewhere in this Form 10-K, you should carefully consider the following factors when evaluating the Company |
| An investment in the Company is subject to risks inherent in our business |
| The trading price of the shares of the Company is affected by the performance of our business relative to, among other things, competition, market conditions and general economic and industry conditions |
| The risk factors listed below are not all inclusive |
| We have outsourced the marketing of our production and have no ability to control the prices that we receive for natural gas and oil |
| Natural gas and oil prices fluctuate widely, and low prices would have a material adverse effect on our revenues, profitability and growth |
| Our revenues, profitability and future growth will depend significantly on natural gas and crude oil prices |
| Prices received also will affect the amount of future cash flow available for capital expenditures and repayment of indebtedness and will affect our ability to raise additional capital |
| Lower prices may also affect the amount of natural gas and oil that we can economically produce |
| Factors that can cause price fluctuations include: • The domestic and foreign supply of natural gas and oil |
| • Overall economic conditions |
| • The level of consumer product demand |
| • Adverse weather conditions and natural disasters |
| • The price and availability of competitive fuels such as heating oil and coal |
| • Political conditions in the Middle East and other natural gas and oil producing regions |
| • Domestic and foreign governmental regulations |
| • Potential price controls and special taxes |
| We depend on the services of our chairman, chief executive officer and chief financial officer, and implementation of our business plan could be seriously harmed if we lost his services |
| We depend heavily on the services of Kenneth R Peak, our chairman, chief executive officer, and chief financial officer |
| We do not have an employment agreement with Mr |
| Peak, and the proceeds from a dlra10dtta0 million “key person” life insurance policy on Mr |
| We are highly dependent on the technical services provided by our alliance partners and could be seriously harmed if our alliance agreements were terminated |
| Because we have only six employees, none of whom are geoscientists or petroleum engineers, we are dependent upon alliance partners for the success of our natural gas and oil exploration projects and expect to remain so for the foreseeable future |
| Highly qualified explorationists and engineers are difficult to attract and retain |
| As a result, the loss of the services of one or more of our alliance partners could have a material adverse effect on us and could prevent us from pursuing our business plan |
| Additionally, the loss by our alliance partners of certain explorationists could have a material adverse effect on our operations as well |
| 18 ______________________________________________________________________ [99]Table of Contents [100]Index to Financial Statements Our ability to successfully execute our business plan is dependent on our ability to obtain adequate financing |
| Our business plan, which includes participation in 3-D seismic shoots, lease acquisitions, the drilling of exploration prospects and producing property acquisitions, has required and will require substantial capital expenditures |
| We may require additional financing to fund our planned growth |
| Our ability to raise additional capital will depend on the results of our operations and the status of various capital and industry markets at the time we seek such capital |
| Accordingly, we cannot be certain that additional financing will be available to us on acceptable terms, if at all |
| In particular, our credit facility imposes limits on our ability to borrow under the facility based on adjustments to the value of our hydrocarbon reserves, and our credit facility limits our ability to incur additional indebtedness |
| In the event additional capital resources are unavailable, we may be required to curtail our exploration and development activities or be forced to sell some of our assets in an untimely fashion or on less than favorable terms |
| (“COI”) is a wholly-owned subsidiary of the Company, formed for the purpose of drilling and operating exploration wells in the Gulf of Mexico and is a recent addition to our business strategy |
| COI is currently the operator for our exploration prospect at Eugene Island 10 |
| Although as a company we have previously taken working interests in offshore prospects, our recent exploration prospects are the first wells in which we have assumed the role of operator |
| Estimated drilling costs could be significantly higher if we encounter difficulty in drilling offshore exploration wells |
| Drilling activities are subject to numerous risks, including the risk that no commercially productive hydrocarbon reserves will be encountered |
| The cost of drilling, completing and operating wells and of installing production facilities and pipelines is often uncertain |
| The Company’s drilling operations may be curtailed, delayed, canceled or negatively impacted as a result of numerous factors, including inexperience as an operator, title problems, weather conditions, compliance with governmental requirements and shortages or delays in the delivery or availability of material, equipment and fabrication yards |
| In periods of increased drilling activity resulting from high commodity prices, demand exceeds availability for drilling rigs, drilling vessels, supply boats and personnel experienced in the oil and gas industry in general, and the offshore oil and gas industry in particular |
| This may lead to difficulty and delays in consistently obtaining certain services and equipment from vendors, obtaining drilling rigs and other equipment at favorable rates and scheduling equipment fabrication at factories and fabrication yards |
| This, in turn, may lead to projects being delayed or experiencing increased costs |
| The cost of drilling, completing, and operating wells is often uncertain, and we cannot assure that new wells will be productive or that we will recover all or any portion of our investment |
| The risk of significant cost overruns, curtailments, delays, inability to reach our target reservoir and other factors detrimental to drilling and completion operations may be higher due to our inexperience as an operator |
| We may have excessive resources committed to our Arkansas Fayetteville Shale Play |
| Our capital budget for our fiscal year ending June 30, 2007 calls for us to invest over dlra40 million in the Arkansas Fayetteville Shale |
| This represents approximately 75prca of our exploration and development budget, and approximately 70prca of our total CAPEX budget |
| We intend to borrow significant capital against anticipated revenues and production, and should the wells not perform as expected, we will likely encounter difficulty repaying this debt |
| There can be no assurance that our drilling activity in this area will produce economically feasible wells |
| It is early in the process and we are still learning how to drill, complete, frac and produce these wells |
| Additionally, all of our wells are operated by outside companies |
| As a result, we have a limited ability to exercise influence over operations or their associated costs and risks |
| Increasing capital investment in certain prospects increases our dry hole risk exposure |
| Beginning in the spring of 2005, we decided to increase our capital investment in certain exploration 19 ______________________________________________________________________ [101]Table of Contents [102]Index to Financial Statements prospects, including our onshore Arkansas Fayetteville Shale prospect and our offshore Gulf of Mexico prospects |
| From July 1, 2005 through August 31, 2006, we have invested, or committed to invest, approximately dlra24dtta4 million in our offshore prospects, and dlra17dtta8 million in the Arkansas Fayetteville Shale |
| This represents a major increase in the risk profile of the Company which in the past has limited its dry hole risk exposure on any one well to approximately dlra1dtta0 million |
| The construction of our LNG receiving terminal in Freeport, Texas is subject to various development and completion risks |
| We own a 10prca limited partnership interest in the Freeport LNG receiving facility that is being constructed in Freeport, Texas |
| The LNG project received approval from the Federal Energy Regulatory Commission (the “FERC”) in June 2004 |
| On January 11, 2005, Freeport LNG received its authorization to commence construction of the first phase of its terminal from the FERC Construction of the 1dtta5 Bcf/d facility commenced on January 17, 2005 |
| Freeport LNG is seeking an additional order from the FERC that would authorize the construction of an expansion that would increase the capacity at its currently permitted 1dtta5 Bcf/d Freeport LNG terminal to 2dtta6 Bcf/d |
| The LNG receiving facility is subject to development risk such as permitting, cost overruns and delays |
| Key factors that may affect the completion of the LNG receiving terminal include, but are not limited to: timely issuance of necessary additional permits, licenses and approvals by governmental agencies and third parties; sufficient financing; unanticipated changes in market demand or supply; competition with similar projects; labor disputes; site difficulties; environmental conditions; unforeseen events, such as hurricanes, explosions, fires and product spills; delays in manufacturing and delivery schedules of critical equipment and materials; resistance in the local community; local and general economic conditions; and commercial arrangements for pipelines and related equipment to transport and market LNG If completion of the LNG receiving facility is delayed beyond the estimated development period, the actual cost of completion may increase beyond the amounts currently estimated in our capital budget |
| A delay in completion of the LNG receiving facility would also cause a delay in the receipt of revenues projected from operation of the facility, which may cause our business, results of operations and financial condition to be substantially harmed |
| If we are not able to fund or finance our 10prca ownership in the LNG receiving facility in Freeport, Texas, including any expansion of the facility, we may lose our 10prca investment in the project |
| A majority of the Freeport LNG financing is being provided by ConocoPhillips through a dlra620dtta0 million construction loan, with debt service being provided by the terminal use agreement with ConocoPhillips |
| Additional financing has been obtained through a dlra383dtta0 million private placement note issuance by Freeport LNG which closed on December 19, 2005 |
| The notes are secured primarily by payments obligated under the terminal use agreement with Dow Chemical |
| Upon any significant increase in construction costs to complete construction of the receiving facility or upon a call to fund construction of the proposed expansion, we may not have the financial resources to fund our 10prca ownership share of construction costs |
| If we are unable to fund our share of the project costs or if the project is unable to secure third-party project financing, we could lose our investment in the project or be forced to sell our interest in an untimely fashion or on less than favorable terms |
| If we default on our Sundance loan we could lose our 10prca investment in the LNG receiving facility in Freeport, Texas |
| Our three-year dlra20dtta0 million term loan agreement dated April 27, 2006 with The Royal Bank of Scotland plc is secured with the stock of Contango Sundance, Inc |
| (“Sundance”), our wholly-owned subsidiary |
| Sundance owns a 10prca limited partnership interest in Freeport LNG Development, LP, which owns the Freeport LNG facility |
| If an event of default occurs under the term loan agreement, we could lose our investment in the Freeport LNG facility |
| 20 ______________________________________________________________________ [103]Table of Contents [104]Index to Financial Statements Natural gas and oil reserves are depleting assets and the failure to replace our reserves would adversely affect our production and cash flows |
| Our future natural gas and oil production depends on our success in finding or acquiring new reserves |
| If we fail to replace reserves, our level of production and cash flows would be adversely impacted |
| Production from natural gas and oil properties decline as reserves are depleted, with the rate of decline depending on reservoir characteristics |
| Our total proved reserves will decline as reserves are produced unless we conduct other successful exploration and development activities or acquire properties containing proved reserves, or both |
| Accordingly, we do not have significant opportunities to increase our production from our existing proved reserves |
| Our ability to make the necessary capital investment to maintain or expand our asset base of natural gas and oil reserves would be impaired to the extent cash flow from operations is reduced and external sources of capital become limited or unavailable |
| We may not be successful in exploring for, developing or acquiring additional reserves |
| If we are not successful, our future production and revenues will be adversely affected |
| Reserve estimates depend on many assumptions that may turn out to be inaccurate |
| Any material inaccuracies in these reserve estimates or underlying assumptions could materially affect the quantities and present values of our reserves |
| The process of estimating natural gas and oil reserves is complex |
| It requires interpretations of available technical data and various assumptions, including assumptions relating to economic factors |
| Any significant inaccuracies in these interpretations or assumptions could materially affect the estimated quantities and present value of reserves shown in this report |
| In order to prepare these estimates, our independent third party petroleum engineer must project production rates and timing of development expenditures as well as analyze available geological, geophysical, production and engineering data, and the extent, quality and reliability of this data can vary |
| The process also requires economic assumptions relating to matters such as natural gas and oil prices, drilling and operating expenses, capital expenditures, taxes and availability of funds |
| Therefore, estimates of natural gas and oil reserves are inherently imprecise |
| Actual future production, natural gas and oil prices, revenues, taxes, development expenditures, operating expenses and quantities of recoverable natural gas and oil reserves most likely will vary from our estimates |
| Any significant variance could materially affect the estimated quantities and pre-tax net present value of reserves shown in this report |
| In addition, estimates of our proved reserves may be adjusted to reflect production history, results of exploration and development, prevailing natural gas and oil prices and other factors, many of which are beyond our control |
| Some of the producing wells included in our reserve report have produced for a relatively short period of time |
| Because some of our reserve estimates are not based on a lengthy production history and are calculated using volumetric analysis, these estimates are less reliable than estimates based on a more lengthy production history |
| You should not assume that the pre-tax net present value of our proved reserves prepared in accordance with SEC guidelines referred to in this report is the current market value of our estimated natural gas and oil reserves |
| We base the pre-tax net present value of future net cash flows from our proved reserves on prices and costs on the date of the estimate |
| Actual future prices, costs, taxes and the volume of produced reserves may differ materially from those used in the pre-tax net present value estimate |
| We rely on the accuracy of the estimates in the reservoir engineering reports provided to us by our outside engineers |
| We have no in house reservoir engineering capability, and therefore rely on the accuracy of the periodic reservoir reports provided to us by our independent third party reservoir engineers |
| If those reports 21 ______________________________________________________________________ [105]Table of Contents [106]Index to Financial Statements prove to be inaccurate, our financial reports could have material misstatements |
| If the reports of the outside reservoir engineers prove to be inaccurate, we may make misjudgments in our financial planning |
| Exploration is a high risk activity, and our participation in drilling activities may not be successful |
| Our future success will largely depend on the success of our exploration drilling program |
| Participation in exploration drilling activities involves numerous risks, including the risk that no commercially productive natural gas or oil reservoirs will be discovered |
| The cost of drilling, completing and operating wells is often uncertain, and drilling operations may be curtailed, delayed or canceled as a result of a variety of factors, including: • Unexpected drilling conditions |
| • Blowouts, fires or explosions with resultant injury, death or environmental damage |
| • Pressure or irregularities in formations |
| • Equipment failures or accidents |
| • Tropical storms, hurricanes and other adverse weather conditions |
| • Compliance with governmental requirements and laws, present and future |
| • Shortages or delays in the availability of drilling rigs and the delivery of equipment |
| Even when properly used and interpreted, 3-D seismic data and visualization techniques are only tools used to assist geoscientists in identifying subsurface structures and hydrocarbon indicators |
| They do not allow the interpreter to know conclusively if hydrocarbons are present or economically producible |
| Poor results from our drilling activities would materially and adversely affect our future cash flows and results of operations |
| In addition, as a “successful efforts” company, we choose to account for unsuccessful exploration efforts (the drilling of “dry holes”) and seismic costs as a current expense of operations, which immediately impacts our earnings |
| Significant expensed exploration charges in any period would materially adversely affect our earnings for that period and cause our earnings to be volatile from period to period |
| The natural gas and oil business involves many operating risks that can cause substantial losses |
| The natural gas and oil business involves a variety of operating risks, including: • Blowouts, fires and explosions |
| • Uncontrollable flows of underground natural gas, oil or formation water |
| • Natural disasters |
| • Stuck drilling and service tools |
| • Abnormal pressure formations |
| • Environmental hazards such as natural gas leaks, oil spills, pipeline ruptures or discharges of toxic gases |
| If any of these events occur, we could incur substantial losses as a result of: • Injury or loss of life |
| • Severe damage to and destruction of property, natural resources or equipment |
| • Pollution and other environmental damage |
| • Clean-up responsibilities |
| 22 ______________________________________________________________________ [107]Table of Contents [108]Index to Financial Statements • Regulatory investigations and penalties |
| • Suspension of our operations or repairs necessary to resume operations |
| Offshore operations are subject to a variety of operating risks peculiar to the marine environment, such as capsizing and collisions |
| In addition, offshore operations, and in some instances, operations along the Gulf Coast, are subject to damage or loss from hurricanes or other adverse weather conditions |
| These conditions can cause substantial damage to facilities and interrupt production |
| As a result, we could incur substantial liabilities that could reduce the funds available for exploration, development or leasehold acquisitions, or result in loss of properties |
| If we were to experience any of these problems, it could affect well bores, platforms, gathering systems and processing facilities, any one of which could adversely affect our ability to conduct operations |
| In accordance with customary industry practices, we maintain insurance against some, but not all, of these risks |
| Losses could occur for uninsurable or uninsured risks or in amounts in excess of existing insurance coverage |
| We may not be able to maintain adequate insurance in the future at rates we consider reasonable, and particular types of coverage may not be available |
| An event that is not fully covered by insurance could have a material adverse effect on our financial position and results of operations |
| Not hedging our production may result in losses |
| Due to the significant volatility in natural gas prices and the potential risk of significant hedging losses if NYMEX natural gas prices spike on the date options settle, our policy is to hedge only through the purchase of puts |
| By not hedging our production, we may be more adversely affected by declines in natural gas and oil prices than our competitors who engage in hedging arrangements |
| Our ability to market our natural gas and oil may be impaired by capacity constraints on the gathering systems and pipelines that transport our natural gas and oil |
| Transportation capacity on gathering systems and pipelines is occasionally limited and at times unavailable due to repairs or improvements being made to these facilities or due to capacity being utilized by other natural gas or oil shippers that may have priority transportation agreements |
| If the gathering systems or our transportation capacity is materially restricted or is unavailable in the future, our ability to market our natural gas or oil could be impaired and cash flow from the affected properties could be reduced, which could have a material adverse effect on our financial condition and results of operations |
| We have no assurance of title to our leased interests |
| Our practice in acquiring exploration leases or undivided interests in natural gas and oil leases is to not incur the expense of retaining title lawyers to examine the title to the mineral interest prior to executing the lease |
| Instead, we rely upon the judgment of our alliance partners to perform the field work in examining records in the appropriate governmental, county or parish clerk’s office before leasing a specific mineral interest |
| This practice is widely followed in the industry |
| Prior to the drilling of an exploration well the operator of the well will typically obtain a preliminary title review of the drillsite lease and/or spacing unit within which the proposed well is to be drilled to identify any obvious deficiencies in title to the well and, if there are deficiencies, to identify measures necessary to cure those defects to the extent reasonably possible |
| We have no assurance, however, that any such deficiencies have been cured by the operator of any such wells |
| It does happen, from time to time, that the examination made by title lawyers reveals that the lease or leases are invalid, having been purchased in error from a person who is not the rightful owner of the mineral interest desired |
| In these circumstances, we may not be able to proceed with our exploration and development of the lease site or may incur costs to remedy a defect |
| It may also happen, from time to time, that the operator may elect to proceed with a well despite defects to the title identified in the preliminary title opinion |
| 23 ______________________________________________________________________ [109]Table of Contents [110]Index to Financial Statements Competition in the natural gas and oil industry is intense, and we are smaller and have a more limited operating history than most of our competitors |
| We compete with a broad range of natural gas and oil companies in our exploration and property acquisition activities |
| We also compete for the equipment and labor required to operate and to develop these properties |
| Most of our competitors have substantially greater financial resources than we do |
| These competitors may be able to pay more for exploratory prospects and productive natural gas and oil properties |
| Further, they may be able to evaluate, bid for and purchase a greater number of properties and prospects than we can |
| Our ability to explore for natural gas and oil and to acquire additional properties in the future will depend on our ability to evaluate and select suitable properties and to consummate transactions in this highly competitive environment |
| In addition, most of our competitors have been operating for a much longer time than we have and have substantially larger staffs |
| We may not be able to compete effectively with these companies or in such a highly competitive environment |
| We are subject to complex laws and regulations, including environmental regulations that can adversely affect the cost, manner or feasibility of doing business |
| Our operations are subject to numerous laws and regulations governing the operation and maintenance of our facilities and the discharge of materials into the environment |
| Failure to comply with such rules and regulations could result in substantial penalties and have an adverse effect on us |
| These laws and regulations may: • Require that we obtain permits before commencing drilling |
| • Restrict the substances that can be released into the environment in connection with drilling and production activities |
| • Limit or prohibit drilling activities on protected areas, such as wetlands or wilderness areas |
| • Require remedial measures to mitigate pollution from former operations, such as plugging abandoned wells |
| Under these laws and regulations, we could be liable for personal injury and clean-up costs and other environmental and property damages, as well as administrative, civil and criminal penalties |
| We maintain only limited insurance coverage for sudden and accidental environmental damages |
| Accordingly, we may be subject to liability, or we may be required to cease production from properties in the event of environmental damages |
| These laws and regulations have been changed frequently in the past |
| In general, these changes have imposed more stringent requirements that increase operating costs or require capital expenditures in order to remain in compliance |
| It is also possible that unanticipated factual developments could cause us to make environmental expenditures that are significantly different from those we currently expect |
| Existing laws and regulations could be changed and any such changes could have an adverse effect on our business and results of operations |
| We cannot control the activities on properties we do not operate |
| Other companies currently operate properties in which we have an interest |
| As a result, we have a limited ability to exercise influence over operations for these properties or their associated costs |
| Our dependence on the operator and other working interest owners for these projects and our limited ability to influence operations and associated costs could materially adversely affect the realization of our targeted returns on capital in drilling or acquisition activities |
| The success and timing of our drilling and development activities on properties operated by others therefore depend upon a number of factors that are outside of our control, including: • Timing and amount of capital expenditures |
| • The operator’s expertise and financial resources |
| • Approval of other participants in drilling wells |
| • Selection of technology |
| 24 ______________________________________________________________________ [111]Table of Contents [112]Index to Financial Statements Acquisition prospects are difficult to assess and may pose additional risks to our operations |
| We expect to evaluate and, where appropriate, pursue acquisition opportunities on terms our management considers favorable |
| In particular, we expect to pursue acquisitions that have the potential to increase our domestic natural gas and oil reserves |
| The successful acquisition of natural gas and oil properties requires an assessment of: • Recoverable reserves |
| • Exploration potential |
| • Future natural gas and oil prices |
| • Operating costs |
| • Potential environmental and other liabilities and other factors |
| • Permitting and other environmental authorizations required for our operations |
| In connection with such an assessment, we would expect to perform a review of the subject properties that we believe to be generally consistent with industry practices |
| Nonetheless, the resulting conclusions are necessarily inexact and their accuracy inherently uncertain, and such an assessment may not reveal all existing or potential problems, nor will it necessarily permit a buyer to become sufficiently familiar with the properties to fully assess their merits and deficiencies |
| Inspections may not always be performed on every platform or well, and structural and environmental problems are not necessarily observable even when an inspection is undertaken |
| Future acquisitions could pose additional risks to our operations and financial results, including: • Problems integrating the purchased operations, personnel or technologies |
| • Unanticipated costs |
| • Diversion of resources and management attention from our exploration business |
| • Potential loss of key employees, particularly those of the acquired organization |
| We do not currently intend to pay dividends on our common stock |
| We have never declared or paid a dividend on our common stock and do not expect to do so in the foreseeable future |
| Our current plan is to retain any future earnings for funding growth, and, therefore, holders of our common stock will not be able to receive a return on their investment unless they sell their shares |
| Anti-takeover provisions of our certificate of incorporation, bylaws and Delaware law could adversely effect a potential acquisition by third parties that may ultimately be in the financial interests of our stockholders |
| Our certificate of incorporation, bylaws and the Delaware General Corporation Law contain provisions that may discourage unsolicited takeover proposals |
| These provisions could have the effect of inhibiting fluctuations in the market price of our common stock that could result from actual or rumored takeover attempts, preventing changes in our management or limiting the price that investors may be willing to pay for shares of common stock |
| These provisions, among other things, authorize the board of directors to: • Designate the terms of and issue new series of preferred stock |
| • Limit the personal liability of directors |
| • Limit the persons who may call special meetings of stockholders |
| • Prohibit stockholder action by written consent |
| • Establish advance notice requirements for nominations for election of the board of directors and for proposing matters to be acted on by stockholders at stockholder meetings |
| • Require us to indemnify directors and officers to the fullest extent permitted by applicable law |
| • Impose restrictions on business combinations with some interested parties |
| 25 ______________________________________________________________________ [113]Table of Contents [114]Index to Financial Statements Our common stock is thinly traded |
| Contango has approximately 15 million shares of common stock outstanding, held by approximately 124 holders of record |
| Directors and officers own or have voting control over approximately 4 million shares |
| Since our common stock is thinly traded, the purchase or sale of relatively small common stock positions may result in disproportionately large increases or decreases in the price of our common stock |