Cobalt is currently about to spud the Lontra, a massive Pre-Salt prospect in offshore Angola (Block 20) that, without exaggeration, is the world’s most highly anticipated wildcat well of all of 2013.

On top of this exciting drill, there are 3-5 additional wells being drilled this year that could lead to 1 billion+ barrel finds. I’m afraid to even write what the upper limits of a potential Lontra find could be, but needless to say it could exceed the entire company’s proven reserves to date.

Cobalt announced a secondary offering this morning of 50,000,000 shares by long time backer Goldman, Sachs & Co. Goldman ponied up a significant amount of the risk capital to bootstrap this world class exploration company and is now reaping its’ just rewards. Goldman has been a seller in the past, and has proven itself to be acting outside of any insider information out there – they have sold large blocks in front of major succesful finds in the past. In other words, I wouldn’t read anything into the chances for Lontra hitting black gold from today’s large sale of stock.

FX Energy is slated to announce the preliminary results from two wells that could be company-defining in size. The Tuchola has already successfully flared gas, approximately 5 million cubic feet per day with traces of condensate. The Plawce is a large frack job being done by Halliburton, which if successful could lead to dozens of similar plays within acreage FX controls. Success on either front could lead to additional reserves worth many multiples of the current stock price.

Cobalt is down around $2/share off the secondary, and that makes the out of the money calls a far better buy today then they were before. I’ve purchased chunks of the Oct $30s, and some Jan 22.5c for good measure. Both are great risk/reward flyers.

FX Energy seems to be suffering from the apathetic attention of a market that is fed up with management’s prior failures. I should know – I was one of those who got stung on last year’s Kutno dud. But the market shouldn’t care about that if either Tuchola or Plawce pan out. I can remove the risk in this name by scooping up the June, September and December 5 calls for pennies. If both of these wells get plugged & abandoned I’m out of this name with little damage, whereas if either one of these pan out I’m good to go. We should know a lot more about both of these wells in the next 4-6 weeks, but to play this spec conservatively I would recommend spreading your chips over the various option months available.

These plays are suitable only for those traders with the ability to sustain 100% losses, as both these calls will go zero if things don’t play out. When I buy such positions, I always ask myself, if, in the event I had 10 similar ‘hands’ to bet on, would I be sitting at this blackjack table and putting ‘gelt on the felt’.

In the case of both Cobalt & FX Energy, the answer is a resounding YES.

At the time of the publication of this QuickNote, the author was long Cobalt Energy calls, and FX Energy calls and common stock. Positions may change at any time.

In meeting minutes provided to Sarepta, the FDA made clear that the agency would consider accelerated approval (“AA”) of eteplirsen after it receives additional data summarizing the existing literature available indicating that dystrophin, a protein necessary for the healthy function of muscle tissue, is a suitable biomarker (a characteristic that is objectively measured and evaluated as an indicator of pharmacologic response) for the FDA to judge the worthiness of eteplirsen as an approvable treatment for DMD. Along with the literature on dystrophin, the FDA asked for an accompanying discussion of the clinical outcomes from the phase II study taking the centrality of dystrophin production into account.

Knee jerk sellers of Sarepta in the after hours were clearly disappointed that the FDA didn’t immediately signal approval to file for AA. However, on a conference call hosted yesterday by Chris Garabedian, Sarepta’s President and Chief Executive Officer, following the press release, Chris made it very clear that the FDA is feverishly working with the company – not against it – in rapidly putting together the necessary backbone for a successful NDA (new drug application) within an AA expedited pathway.

On this conference call Chris pointed out that the dystrophin data the FDA seeks is a written “white paper” (Chris’ words) summarizing the detailed presentation Sarepta made to the FDA at the March meeting. Basically, Chris explained that the FDA staff in question reviews dozens of different drug classes and diseases, and is looking towards Sarepta as the expert repository for all things DMD and dystrophin related to properly document the well-known link between DMD and dystrophin.

If the FDA had any questions at all regarding the efficacy of eteplirsen, the discussion would have revolved around a larger confirmatory trial to cement eteplirsen as a viable treatment for DMD. Instead, all the FDA is requesting is the backup on file to validate the position that eteplirsen is a therapeutically valid treatment because dystrophin production is the correct marker to measure efficacy in the first place.

The difference between the two positions may sound subtle, but in reality its’ worlds apart. If the FDA had any troubling questions regarding efficacy due to the low number of patients in eteplirsen’s Phase IIb trial you can bet that the meeting minutes would have looked much, much different.

In my first published piece on Sarepta I laid out the case for dystrophin as a suitable biomarker for DMD. I also penned a more recent piece here on Equities.com discussing why I felt the top brass at FDA have been signaling a more creative approach to expediting the product launches at companies such as Sarepta

Sarepta’s next step is to submit the ‘white paper’ and an associated discussion of the clinical outcomes in the Phase IIb, which Chris indicated will get done shortly. He also indicated that it’s possible a meeting gets calendared for this quarter, with the minutes from that meeting due in early Q3. In the meantime, work on preparing for full-scale production is continuing at a rapid pace, which should put the company in a prime position to be able to supply enough drug for the post-approval confirmatory study to be kicked off in Q4 (if AA is not granted, this large confirmatory study would be powered high enough to substitute for a full blown phase III confirmatory trial) as well as the hundreds of boys expected to clamor for the first batches of drug once approved for marketing.

Many people have asked me why the FDA would want a background piece on dystrophin drawn up if the outcome is already known given eteplirsen’s solid efficacy signal. My response is that this will be used not only as a template for future DMD treatments – reason enough for the FDA to require it – but also to enforce new policy within the FDA ensuring adequate access to the AA pathway in the future. Requiring drug makers to extensively document what constitutes an acceptable biomarker can only lead to increased certainty going forward for other future rare disease treatments. If it is truly to be a ‘New Day at FDA’, there can be no questions asked as to which biomarkers the FDA ultimately relies upon in lieu of larger (and more time consuming) confirmatory drug trials.

One might rightfully criticize Sarepta for going into the end-of-Phase II meeting thinking an oral presentation would be sufficient to nail down this question of dystrophin as an acceptable biomarker, but the point is moot. Sarepta, for better or worse, is treading on new ground, especially since it’s looking for approval not just for eteplirsen but for an entirely new pathway to accelerate additional drugs targeting other DMD mutations outside of the more common Exon 51.

It’s clear that a lot went right at FDA, and I strongly suggest Sarepta shareholders replay yesterday’s conference call to fully understand the nuances that Chris made reference to. Gone were any fears that the design of the Phase IIb trial, including the low patient size and mid-trial unblinding of the cohorts, would be at all troubling to the FDA (Remember that the Sarepta bears made much hay over the supposed coming requirement for Sarepta to validate the efficacy signal with a larger study).  Chris specifically blew apart the risk that a lack of linearity between dystrophin production and walking results would torpedo the efficacy signal by explaining in detail the interaction Sarepta had with the agency on this particular issue.

What all this means is that the FDA requesting additional information should not slow down one bit the process of getting eteplirsen to market as a treatment for boys in desperate need of hope. This is key to understanding why both Jenn McNary and Christine McSherry, two well-known DMD advocates who have met with top FDA officials numerous times, were quoted by Adam Feuerstein of TheStreet.com in a piece published last night as “[feeling] pretty good about this – This is what the FDA told us they’d do.”

In my opinion, assuming that the FDA accepts Sarepta’s background paper on dystrophin without additional follow up questions, you could see a green light being given on AA as soon as September. Chris made it quite clear that the door is open within the FDA to fast track a meeting to review Sarepta’s written response, something I honesty believe he wouldn’t have mentioned if it wasn’t true.

If you purchased stock back in early March when I first published on Sarepta you should be ahead by around 20%. I see no reason to get cold feet given the strong positive signals emanating out of the FDA. I suspect that the stock will work it’s way higher once all the short term call buyers betting on a fast granting of AA are cashiered out and the long term holders of stock buy the relative weakness. Similar to the action we saw in April, Sarepta stock should find itself higher once the market refocuses away from yesterday’s ‘disappointment’ and more towards the significant de-risking that occurred due to the FDA’s positive commentary on ultimately approving eteplirsen.

At the time of the publication of this report, the author was long Sarepta common stock, long Sarepta 29 & 35 strike calls, and short 40 & 42 strike calls.

Investors as a whole live with the risk because the rewards are huge. Warren Buffett has been quoted as saying, “In business, I look for economic castles protected by unbreachable ‘moats’”. Nowhere in the marketplace can you find a product with as solid a moat as a life-saving drug. Companies like Merck, Pfiezer and J&J have pocketed billions of dollars annually, with little in the way of individual competition, by selling drugs that transform the lives of those take them.

Within the pantheon of successful drugs, one cohort stands alone as being virtually impregnable, providing its’ owners with hundreds of millions of dollars in annual profit and almost no chance of competitive pressures impacting market share – namely the class of ultra-orphan drugs. These therapies target extremely rare diseases afflicting a handful of patients. Since the pool of patients is extremely small, drug companies marketing treatments for rare diseases can get away with charging hundreds of thousands of dollars a year per patient.

BioMarin Pharmaceutical (Nasdaq: BMRN) illustrates the riches that come along wtih successfully launching an ultra-orphan drug. In 2005 BioMarin received approval from the FDA to market Naglazyme, a therapy for children born with Maroteaux–Lamy Syndrome (MPS VI). Children born with MPS VI lack certain enzymes needed to break down molecules that help build bone, cartilege, skin and connective tissue. Although no definitive studies have been done, it appears that the rate of incidence of MPS VI  approximates one birth out of 500,000.

To treat this extremely rare disease, BioMarin charges more than $600,000 a year. Sales of Naglazyme last year were more than $250 Million, or around 50% of BioMarin’s total sales. Trading around $61 per share, BioMarin has a market cap of more than $7.7 billion, implying that the Naglazyme franchise has a value exceeding $3 billion dollars. With the success that naglazyme is having in helping patients who suffer from MPS VI – coupled with the extremely small market size of patients – there is little to no chance that another drug company will develop a competing product, leaving this highly profitable market in BioMarin’s hands for a long time to come (it is worth noting that as a biologic, it is very difficult to manufacture. Because of this, it is extremely unlikely that once the drug comes off patent a generic reproduction can be made by another company that is therapeutically 100% exactly the same).

Historically, the time it takes to develop, test and shepherd a drug through the FDA approval process has been so long that patients can literally die while waiting for a promising drug to get to market. However, recent legislative and regulatory developments have made it so that the FDA has become more responsive to patient’s wants and needs in seeing potentially life saving drugs come to market faster. In 2012 Congress passed the FDA Safety & Modernization Act (better known as FDASIA / PDUFA V) which expanded provisions embedded in a previous set of legislation from 1997 known as the FDA Modernization Act (FDAMA).

One of the main goals of PDUFA V was to expand the ability of drug manufactures to collaborate with the FDA in speeding up the approval process of treatments for rare but life-threatening illnesses. The ultra-orphan drug market was a prime target of this legislation. Together, FDASIA and PDUFA V lay down alternative, expedited pathways for drug companies to gain approval for this class of treatments without all the belt-and-suspenders work of multiple, large trials designed to prove efficacy and safety beyond a shadow’s doubt.

One of the prime beneficiaries of this new approach by the FDA could be Sarepta Therapeutics (Nasdaq: SRPT). Sarepta is developing eteplirsen, a novel treatment aimed at a subset of young boys suffering from Duchenne muscular dystrophy (DMD). DMD is the result of a genetic mutation that inhibits a person’s ability to manufacture dystrophin, a necessary component in healthy muscle tissue. Boys who suffer from DMD begin to show symptoms at an early age, and it is a progressive degenerative disease which eventually affects all voluntary muscles in the body. The average life expectancy of a boy born with DMD is 25; there currently is no treatment for the disorder.

In October 2012 Sarepta reported stunning results for a 12-patient phase II study of eteplirsen. The results were so earthshattering that the stock almost tripled the day they were announced. Since that time, the stock has been volatile, dropping from the low 40s to the 20s as Sarepta took advantage of its’ high-flying stock price to raise $125 million from institutional investors and prepare for large-scale commercial manufacturing of eteplirsen.

Normally, a company that completed a succesful phase II study would then seek to complete a pivotal (phase III) trial before approaching the FDA for approval to sell the drug. However, under the expanded mandate Congress gave the FDA to speed up the approval process for rare and fatal diseases, Sarepta has approached the FDA with the intent to seek out its’ permission to file for accelerated approval (AA). It is uncommon for the FDA to grant a company the ability to file for AA, and there is much disagreement amongst the analysts and investors in the biotech community as to whether or not Sarepta will be granted this authority for eteplirsen. The stakes are not small in this debate; the consensus seems to be that if Sarepta is granted AA the stock will climb significantly past $40, whereas if it is forced to proceed first with a larger phase III the stock could swoon to $20 (it last closed around $30 a share).

I have written in the past regarding both the both the bull and bear arguments for Sarepta and why I thought the chances of the company being granted AA were high (you can find my earlier work linked here). There are respected opinions on both sides of the debate (for the record, JMP Securities sees the chances of AA as 20-30%, Piper Jaffrey at 50/50, and Lazard appears equally bullish) and any potential investor in Sarepta should familiarize himself with both sides of this argument.

Sarepta is slated to meet with the FDA sometime in March to learn whether or not the Agency looks favorably on the company filing for AA. Sarepta plans to release the decision as soon as it receives written minutes from the meeting confirming the FDA’s decision. Until such time, investors will not know for certain what the outcome is, and the resulting uncertainly will continue to add volatility to Sarepta’s stock price.

However, investors continue to look for scraps of incremental information that might shed light on which way the FDA is leaning. To that effect, I believe an important piece of information has recently come to light that adds credibility to the argument that the FDA will ultimately fast track eteplirsen’s approval.

Dr. Janet Woodcock is the director for the Center for Drug Evaluation and Research (CDER), the division at the FDA responsible for evaluating prescription and over the counter drugs before they are approved for sale within the United States. The researchers who oversee Sarepta’s interactions with the FDA are all housed within CDER. As director, Dr. Woodcock sets the tone for all her staff and therefore her approach towards novel drugs targeting rare and fatal illnesses should be highly influential towards whether or not eteplirsen is granted AA status.

On Thursday, March 7th, a small company that produces life science related podcasts (known as mendelspod.com) published a 20 minute interview with Dr. Woodcock (the full audio of the podcast can be accessed here). The host, Theral Timpson, steered the questioning towards a deeper understanding of Dr. Woodcock’s apparent shift within CDER towards a faster and more streamlined approval process for new and cutting-edge drugs that could potentially save lives.

Much of what Dr. Woodcock has to say about getting such drugs to the market faster would seem to shed favorable light on Sarepta’s chances for AA. In fact, some of her comments are so on the mark that they almost seem to be directed toward eteplirsen itself. Consider the following snippets taken from the interview :

TT (Theral Timpson) :  I just want to start by quoting from their article there that was really praiseworthy. “Under Woodcocks leadership, the agency has become more surefooted in its approach to new molecular entities.  Groups within CDER took swifter action on most new drugs last year that the agency’s counterparts in Europe and elsewhere.”  And then the article goes on here to say, “The agency’s taken a more rational approach using molecular data that supplies evidence at an early stage.” Do you agree with this? Do you find you’re changing the approach there?

JW (Janet Woodcock) :  Well I think the approach is changing.  And certainly I’ve been in the front of advocating for some of these things. For example, since 2004 I’ve been pushing that we should use biomarkers, that more biomarkers need to be developed…. over the last 4 years, we’ve seen a lot of genomic biomarkers and targeted therapies now, that we’re now being able to approve.

JW: A lot of these targeted therapies have a larger treatment effect.  So it’s easier to see that they work.  And it also requires a smaller number of  people in trials to demonstrate that they’re effective. So this has been very positive I think both for the industry and for the FDA.  And we’re seeing the effects in rare diseases, diseases of children and so forth that have been intractable in therapy for a long time and this is also very positive.

JW: A number of companies are beginning to adopt this (approach to targeted therapeutics ed.).  And it is really sort of the concept of precision medicine or targeted therapy, that you know more about who your treating.  You know, perhaps more about the effect of the intervention, you can monitor it better and hopefully, what we’re all hoping for is we see more successful development programs.

TT: So I’m wondering if you have a story of a truly powerful medication that has, so to speak, come across your desk.

JW: Well, I do, but we don’t tend to single out products and endorse them…

I recommend that all investors interested in following Sarepta should carefully listen to the entire interview. There aren’t more than a handful of targeted treatments (eteplirsen targets exon 51, a small strand of DNA that certain DMD patients have a mutation) dealing with rare and intractable children’s illnesses that are currently front and center at CDER. Dr. Woodcock specifically points out, more than once in the interview, that targeted therapies in rare diseases should require smaller number of people in trials in order to demonstrate that they are effective. She makes reference to identifying biomarkers - a characteristic that is objectively measured and evaluated as an indicator of pharmacologic response – in order to aid in identifying candidates for approval. In the case of eteplirsen this would naturally be the production of dystrophin, which Sarepta has proven in its’ Phase II to be a succesful byproduct of receiving a continuous infusion of eteplirsen.

Elsewhere in the interview Dr. Woodcock makes an impassioned argument as to why rare illnesses ought not to require multiple large trials to confirm “astounding” clinical outcomes before approving a treatment. She discusses balancing the needs of safety and therapeutic outcome, in which she turns”to (my) own individual judgement on what I think is right – what’s right for the people, who are my customers, which are the patients.”

In the case of the DMD community they have been extremely vocal about what is right for them. Again, see my earlier piece for more detail on how the position of DMD patients and activists impact eteplirsen’s chances for AA. It’s clear to me that Dr. Woodcock is validating their needs and interests in her comments to Theral Thimpson.

Ultimately the bear argument on why eteplirsen would not be granted AA boils down to the small sample size the drug has been tested on. Listening to the entire interview with Dr. Woodcock I believe most casual observers would come to the conclusion that such worries are unfounded in the case of “astounding” clinical outcomes. No one doubts that the handful of children in the trial whose lives have been irreparably changed for the better is nothing short of astounding.

The FDA has numerous safeguards in place to assure that a drug receiving AA continues to undergo scrutiny from the Agency to ensure that the drug should remain on the market. Foremost amoungst those procedures is the responsibility of companies granted AA to undergo a larger confirmatory study at the same time they are marketing the drug to patients. Sarepta is quickly moving forward with making the necessary capital expenditures to ensure an adequate manufacturing capacity for both the confirmatory study and the commercial market. If granted the right to file AA, it appears likely that accomplishing both the study and commercial sales would begin in earnest in 2014 – at least 2 years ahead of where patients would be if they had to wait for the drug to crawl through the normal approval process. For many exon-51 DMD patients those extra two years would be a bridge too far.

As mentioned above, all investments in biotech belong to a class of investments that are amongst the riskiest types of equity investments individual investors could make. However, I believe the evidence, including the recently released interview with Dr. Woodcock, make Sarepta an attractive investment for those investors looking for exposure to the ultra-orphan drug market.

At the time of publication of this article, the author maintained a long position in Sarepta Therapeutics

Therefore, one of the first things I do when sizing up a special situation is to take a look at the options pricing. Firms that sell lottery tickets know that they can pay out spectacular sums on such exotic bets, and therefore do their utmost to ensure the proper pricing for those wishing to take such flyers. When there is a catalyst in the wings that could impact the valuation of a stock significantly one way or the other the options pit should be the first place to look and see what conventional wisdom thinks about the odds of such an event. Companies that are in the process of selling themselves almost always have elevated options pricing, to factor in the risk that a deal gets announced at a sizable premium. Biotech companies awaiting word on a new drug application (NDA) can sometimes have some of the highest options pricing of all listed equities.

However, there are always exceptions. And while the most dangerous words in investing are “Its’ different time” in the case of Sarepta Therapeutics (Nasdaq: SRPT), this time it may just be truly different.

Sarepta Therapeutics’ lead drug candidate is Eteplirsen, a treatment for a class of patients with Duchenne muscular dystrophy (DMD). Eteplirsen is one of the first novel treatments to come out of antisense therapy, a technology with tremendous promise but to date few results. Antisense relies on scientists’ ability to insert genetic material to effectively ‘silence’ harmful genes by targeting a section of RNA with an antisense oligonucleotide. Since the first experiments in 1978 successfully inhibited a sarcoma virus, scientists have long known that serious illnesses based upon genetic mutations would be prime candidates for antisense therapy. However, to date only two antisense treatments have made it through the FDA, fomivirsen (Vitravene) in 1998 and  mipomersen (Kynamro) in January of this year. Although dozens of antisense treatments are currently in development, it is fair to say that to date the technology has been long on promise but short on results.

There are few genetic disorders more catastrophic then DMD. Approximately 1 out of every 3,600 boys are born with this genetic defect. It is caused by a mutation in the dystrophin gene, located on the human X chromosome, which codes for the protein dystrophin. Dystrophin plays an extremely important role in developing healthy muscle tissue. Without the proper level of dystrophin, a young boy will build up excess calcium, which ultimately penetrates the cell membrane causing all sorts of havoc. Around age 10, DMD patients experience a rapid deterioration of muscle tissue, causing extreme difficulties in walking and other muscle-intensive tasks. As the deterioration progresses, patients require the use of a wheelchair, and ultimately, full paralysis sets in. The average DMD patient lives to about age 25.

The dystrophin gene is composed of 79 exons. Boys born with DMD will have a mutation in one of the exons, which can be easily identified with DNA testing. Eteplirsen is designed to ‘skip over’ exon 51, which at 13% of the DMD patient population comprises the largest DMD subgroup (In the US there is a market of 35,000 DMD patients of which approximately 1,900 have a mutation in exon 51). By skipping over the mutated gene, eteplirsen allows the cells to produce healthy dystrophin mRNA, which in turn expresses within the muscle therapeutically active (although truncated somewhat) dystrophin.

On October 3rd, 2012, Sarepta Therapeutics released the first 48 weeks of results from a Phase II 12 patient study based out of Nationwide Children’s Hospital in Columbus, Ohio. These 12 boys, ranging in ages 7 through 13, all carried the defective exon 51 gene. Of the twelve, 4 patients received placebo, 4 received 30 mg/kg of eteplirsen, and the final 4 patients received 50 mg/kg of eteplirsen once weekly for 24 weeks.

The results were shocking. Muscle biopsies done at weeks 12 and 24 showed that the treated population gained dystrophin-positive fibers within the muscle comprising a 47.0% improvement from baseline dystrophin levels. The treated group was thus able to significantly outperform in the trial’s stated primary clinical endpoint – a standardized 6 minute walking test (6MWT). In the 6MWT, the treated group’s out-performance became more significant as time went on. The results from both the muscle biopsies and the 6MWT were both significant enough to convince the oversight committee to ‘unblind’ the trial midway and ensure that the placebo group would get the benefit of eteplirsen as well.

Although the patient size was extremely small, the results were so astoundingly different between the placebo and eteplirsen groups as to be extremely statistically significant. Statistical significance in medical trials is known as a ‘p-value’, which is a statistical tool that estimates the probability that results are due to chance. The p-value in the combined 30mg & 50mg cohorts was less than 0.001, virtually ruling out randomness as a reason for the trial’s success.

As exciting as the statistical significance of the primary endpoints was the clean safety data generated throughout the trial. No clinical treatment-related adverse events were observed and no patients were discontinued treatment due to any serious adverse events. This is especially important since a competing treatment currently in trials (Glaxo’s drisapersen) recently saw a number of trial participants hospitalized  due to kidney toxicity and low platelet counts (hat tip to Adam Feuerstein for being the first to publish on the severity of the safety data).

The succesful Phase II was not the first time eteplirsen was tested on humans. Since Sarepta began developing the drug, it has been tested in 38 DMD patients across 4 studies. 28 out of 36 DMD patients treated with eteplirsen who received muscle biopsies showed increased dystrophin production (% positive fibers) from baseline, including 20 out of 20 who received at least 10mg/kg/wk (From page 18 of January 2013 presentation)

In December Sarepta released updated data from the trial, which followed all the patients through week 62.  Patients treated with eteplirsen for 62 weeks maintained a statistically significant benefit on the primary clinical endpoint (6MWT), compared to patients who received placebo for 24 weeks and then received eteplirsen for the remaining 38 weeks. Shortly thereafter Lazard raise Sarepta $125 million in a stock offering priced at $25.25 per share. Combined with the money raised from the green shoe, the company ended 2012 with more than $180 million in cash, more than enough funds in the bank to see eteplirsen to market.

Historically, drug companies like Sarepta would need to plan a Phase III study comprising far more patients than the Phase II before approaching regulators to file an NDA (New Drug Application). However, in the case of young boys reaching puberty and just beginning to suffer the life-threatening effects of DMD, waiting for a comfirmatory study before marketing the drug would amount to a death sentence.

With the passage of the FDA Modernization Act of 1997 (FDAMA) and amended in 2012 by the FDA Safety & Innovation Act (FDASIA), Congress created a pathway for rare diseases to receive fast track and accelerated approval (AA). Sarepta has made it clear that they intend to petition the FDA to allow the company to apply for AA and have a meeting with the FDA on this very topic scheduled shortly.

What are the conditions necessary to meet the requirements for AA? Sec 901 of FDAMA and FDAISA govern access to AA. Section 902 complements 901 by allowing expedited developement of ‘Breakthrough Therapies’ that benefits drugmakers by giving them frequent, prioritized access to FDA staff to help expedite the approval process.

Section 901 lays out three broad criteria that need to met in order to achieve AA status. The disease in question must be rare and life threatening. A surrogate endpoint needs to be identified that is reasonably likely to predict clinical benefits to prospective patients. And lastly, safety data is carefully weighed on a risk vs. benefit analysis, taking into account the needs and viewpoints of patients.

Section 902 works hand in hand with Section 901 by allowing a company access to FDA staff  in order to ensure the most efficacious method to reach AA compliance. Importantly, Section 902 directs that clinical trials be both small and efficient (in the words of the statute “by minimizing the number of patients exposed to a potentially less efficacious treatment”)

It is clear to me that by all accounts a succesful treatment for Duchenne’s meets the criteria necessary to achieve AA. No one doubts that boys suffering from Duchenne’s are literally given a death sentence. While there are outlier cases of DMD patients living into their 50s, they are few and far between. Such standouts achieve extraordinary longevity through heroic usage of ventilators and other medical equipment leading to significant loss of quality of life. The sad fact is, the vast majority of DMD boys will not live to see their 30th birthday. There is currently no cure or treatment on the market that can change these grim statistics. In fact, it would not be far from the truth to say that a disease like Duchenne’s was the impetus for Congression action via FDAMA/FASIA in the first place.

It is also clear to me that the data on Eteplirsen meets the legislative intent of Section 901. The evidence linking the failure to properly express dystrophin mRNA with the deterioration of muscle is both widespread and without question accepted within the muscular dystrophy scientific community (This website maintained by UCLA is a good primer on this subject). Sarepta has proven the existence of dystrophin production in all 12 patients in the trial who received the drug – including the 4 placebo patients who subsequently went on treatment after week 24.  Slides showing images from both the pre- and post-treatment cells taken from muscle biopsies are available on pages 12 & 13 of the January 2013 presentation. These images are stark examples of eteplirsen having the therapeutic effect of allowing the patient to manufacture dystrophic-positive fibers in the sarcolema (the membrane covering muscle fiber).

Without question, the safety data generated at trial was a home run when considered against the life-threatening nature of the illness. It’s not a stretch to say that of all the Section 901 hurdles, the safety profile of eteplirsen is the least worrisome of all.

The FDA is mandated to meet with a drug company developing a Section 902 Breakthrough Therapy in order to inquire as to Section 901 compliance within 60 days of requesting such a meeting (assuming the company in question meets all other statutory guidelines such as complete data submission, etc.) According to Sarepta’s CEO the request was made sometime in late December, so unless the FDA requested a short extension such a meeting has already occurred or is immediately about to. The company has also guided that they will make public the results of such a meeting once they receive the official transcript from the FDA, which is usually a 30 day process post-meeting. If the FDA ultimately decides to grant Sarepta the right to make an AA filing, it is accepted wisdom that this decision stems from the FDA’s opinion as to the positive merits of eteplirsen and therefore makes it extremely likely that the drug will ultimately get approved in a timely fashion.

Assuming approval, the future for Sarepta would be extremely bright. Orphan drug pricing is extremely high. The average price of 10 orphan drugs tracked by the company as comparables is $350,000. There are approximately 1,900 patients in the US amenable to being treated with an exon 51-skipping drug. At $350,000 per patient per year (eteplirsen is a maintenance therapy that would conceivably be given for life) that gives the company an addressable market for eteplirsen of $600m+. Sarepta is in the early stages of adjusting its technology to exons 45, 50 & 53 and there is no conceivable hurdle at present aside from regulatory red tape that would not make these additional drugs not feasible  Ultimately, if succesful with eteplirsen and its cohorts, this market could yield billions of dollars in yearly revenue within the US alone.

Options pricing can be an extremely useful tool in analyzing what the current expectations are for this market-moving piece of information to be released. If you look at the difference in pricing between the March, April & May 35 calls, you will see a clear jump in premium and associated volatility starting in April. Therefore it is reasonable that the specialists making a market in Sarepta options expect a decision by the FDA to be released sometime after March 16th, the expiration of the March series of options.

Normally I would agree with the pricing in options on such a speculative and closely-watched name like Sarepta. However, I believe in this case there are a number of key upcoming catalysts that could both put the March options ‘in play’ as well as yield a short-term bounty to Sarepta stockholders.

On Monday, March 4th, the company will speak at the Cowen Health Care Conference in its’ hometown of Boston. On Thursday March 7th, the company will release earnings along with a corporate update. Either venue would be a good place to update shareholders as to the status of the AA meeting. It is highly probable, that the meeting will have already taken place by the time of the earnings announcement, and any body language or comforting comments around the process would be taken seriously by Wall Street.

It is also possible that Sarepta releases additional data on the ongoing open-label extension study with the original 12 patients. The extension study continues to assess the long-term safety and efficacy of open-label eteplirsen. The 6MWT continues to be performed every 12 weeks, and it is possible that the company releases that data publically. In the December 7th release of data, a continued benefit on the 6MWT was shown to exist through 62 weeks and if it continues to be replicated over time will add urgency to the push to get this drug fast tracked.

There is much controversy, stoked by a few well-disseminated bear pieces written about the chances of AA approval (the most widely read piece is the one on TheStreet.com written by Aafia Chaudhry) that have added unnecessary volatility to the stock. The bear argument revolves around 3 main points of contention. Bears argue that the small size of the trial is not conclusive enough to meet AA requirements. Bears further argue that unblinding the trial after week 24 taints the data enough to invalidate the study for purposes of meeting Section  901. And lastly, some of the bears have argued that there isn’t enough conclusive evidence that dystrophin-positive fiber counts predict clinical outcomes (6MWT performance) in DMD patients.

The idea that the trial was not large enough to meet AA requirements is laughable. Trial participant sizes are viewed through two lenses. Firstly, did the data generate enough successful data points to lower the p-value to an acceptable threshold? Modern science accepts a p-value of 0.05 or less to be statistically significant. The fact that the p-value was less than 0.01 is the main criteria by which the FDA will example the proposed efficacy of the drug.

The second lens through which the FDA examines trial size is to look at the size of the patient population residing within the US. The number of exon-51 patients is approximately 1900. However that number significantly overstates the number of eligible for-trial patients, as many of these boys have passed puberty and begun to show significant muscle deterioration. A significant percentage of the exon-51 population will, unfortunately, pass away in the next 24-36 months. When compared to the population size, a trial comprised of 12 patients is more than enough, in my opinion, to convince the FDA as to the efficacy and safety of this drug (As an aside, about 3 years ago I had a conversation with the CEO of a drug company attempting to work out the details of a pivotal trial in the US for a rare genetic disease afflicting approximately 500 people. The FDA indicated to him that it would be acceptable in this case to run a trial of only 3 or 4 patients!)

When the results of the dystrophin production in the treated arm became clear to the researchers in the trial, they immediately shifted the trial from a placebo-controlled double blind to an open-label extension  This was a both scientifically correct procedure as well as a morally obligatory one. To argue, as some do, that the company needed to choose between making the proper ethical decision versus tainting the results and irreparably delaying the availability of the drug to the hundreds of needy patients is an argument that the FDA has dealt with in the past. Companies running drug trials are expected to adhere to highest ethical standards applicable, and the FDA has in the past approved numerous drugs on the basis of open-label studies where all participants would be irreparably harmed should they be denied access to a life-saving drug by virtue of being stuck in the placebo arm.

Lastly, the criticism that some have leveled at the linkage between DMD patients and a lack of dystrophin production shows a profound disregard for the state of science in the DMD community. I have not read a single piece of research on Sarepta that quotes an expert in this field questioning this link. All the major research programs underway in muscular dystrophy accept this linkage as a basis for further research, and anyone doing a cursory examination of the latest published research in the field will come across numerous publications that accept this premise. Any scientific panel stacked with experts in muscular dystrophy would be well aware of this basic accepted fact.

Many of these bearish arguments could fall by the wayside with the release of 72 week data from the open label extension study. What I find potentially meaningful in any new data released is the inclusion of the treated placebo arm. As mentioned above, after week 24 the trial was unblinded and the 4 placebo patients were put onto eteplirsen. The 72 week data will include 48 weeks of treatment data for this 4 patient arm, essentially increasing by 50% the trial size of treated patients at this important threshold (the original data set showing a successful meeting of the primary endpoint was measured at week 48) . If the data shows that these 4 patients have stabilized and maintained walking ability at the crucial 48 week milestone (as they appeared to begin to do at week 36) it will go a long ways towards silencing the bears’ argument that the data set is not robust enough. Again, I don’t think the March option pricing is taking this possible scenario into consideration, as the market for Sarepta’s common stock will need to adjust if the news is positive, based upon the increased chances of the FDA granting AA.

There is a very vocal support group surrounding DMD led by Jenn McNary (you can follow her twitter feed here and her website, DMDHero here). Jenn’s plight is particulary heartbreaking as she is the mother of two DMD afflicted sons, both with exon 51. One son, Max, 10 years old, was accepted into the trial while the other son, Austin, age 13, was not due to his deteriorated condition. Numerous articles and news clips have highlighted her story, which she has reluctantly undergone in order to further the cause of speeding up approval and potentially saving Austin’s life.

Jenn believes very strongly that the drug has postively impacted Max’s life. Unlike his wheelchair-bound brother, he runs down hallways and recently started opening jars with his bare hands. Lately Jenn has posted a number of videos, including this recent one from late February of Max purportedly skiing for the first time (I found it fascinating that this video has been played only 200 times. If anyone had any doubts that patients fell off the wagon after week 62 this video should put them rest for at least one of the subjects. You would think given all the attention this trial has received that others would be as focused on the patient participants and had come across this video!).

Jenn and others have lobbied hard for the FDA to approve an AA submission for eteplirsen. In her case, she suffers at the sight of her older son’s ongoing physical  deterioration and wants to opportunity to arrest his disease progression by giving him eteplirsen as well. Unfortunately Sarepta cannot provide her with the medication due to the drug’s currently unapproved status. Jenn has therefore been at the vanguard of appealing to the FDA – which under FASIA the FDA is mandated to take into account the opinions of rare disease patients and advocates – and organizing letter writing campaigns and trips to Washington DC (This link is especially instructive as the group met with Janet Woodcock; Director of the Center for Drug Evaluation and Research (CDER) and discussed with her the use of Breakthrough Designation and Accelerated Approval pathways to expedite eteplirsen’s approval) in order to accomplish her going of saving Austin’s life.

I have spoken with Sarepta shareholders who have tracked down other families with children in the trial and I’m told the passion surrounding eteplirsen’s efficacy is as great if not greater in those families as well.

On March 11th, Jenn’s group is scheduled to meet with FDA Commissioner Margeret Hamburg. As surprising as this may sound, this single piece of information may be the most instructive of all.

Dr. Margeret Hamburg was first appointed Health Commissioner of New York City in 1991 by then-Mayor David Dinkins. Her accomplishments stood out enough that 3 years later she was one of the only leaders from Dinkins’ inner circle to be asked by newly-elected Mayor Rudolph Giuliani to stay. If you know anything about New York City politics this accomplishment speaks for herself. Dr. Hamburg stood out precisely because of her effectiveness in implementing a number of modern medical improvements to the City’s vast pulic health system, no small feat in the bureaucratically-hidebound NYC DOH (Department of Health). I had a family member working at the upper levels of the health administration and I can tell you firsthand that Dr. Hamburg was successful both because she had an excellant grasp of the medical field and because she was a consummate politician in effectuating her decisions within the organization that she led. Under her tenure New York City significantly lowered the incidence of tuberculosis (then ravaging numerous NYC immigrant communities) and drastically increased the rate of childhood immunizations.

She was given credit for much of these accomplishments, and in 1997 was appointed by the Clinton administration to become assistant secretary for planning and evaluation at the federal Department of Health and Human Services, where she both started a bioterrorism program and oversaw planning for a potential pandemic flu response. Again, she was successful at the Federal level both for her expertise in the medical field and for successfully navigating Washington politics in connection with accomplishing her stated medical goals.

From my vantage point, the idea that Dr. Hamburg would agree to meet in a well-publicized manner with Mrs. Jenn McNary and her group, while knowingly planning to deny the right to submit an AA application for etelplirsen betrays a lack of knowledge as to how Washington DC operates.

I’ve interacted over the years with experts involved in interacting with the FDA on numerous drug submissions. I can tell you that all politicians within government (and make no mistake about it, Dr. Hamburg didn’t get to where she is today by lacking political judgement) seek to attach themselves to the winning horse. In this case, the winning horse is Jenn McNary and her fellow activists who are out to save the lives of children. The FDA has already met with the patient advocates at the operational level (again, see the DMDHero notes from the February 15th meeting) and Dr. Hamburg, knowing as she does the status of etelplirsen within the FDA, could have easily declined the meeting if she felt the outcome was going to be a negative one. This meeting is so close to the FDA’s decision that any new information coming out of it would fail, in my opinion to affect the FDA’s decision.

So why agree to meet? It’s simple really – I believe Dr. Hamburg is meeting with the group this close to the decision point so that when the good news is handed down, the photo ops, the Washington Post article, the lavish specialty medical journal coverage can all point to Dr. Hamburg as one of those ‘heroes’ alongside the smiling McNary clan. Seriously, does anyone who knows something of her career expect her to agree to meet with these activists while knowingly planning to shoot them down a few weeks later??

You don’t have to be a cynic or believe in the bad intentions of Dr. Hamburg – I know for a fact that she is a consummate physician. Rather, in our democratic/capitalist system, impacting public opinion is a necessary prerequisite to getting anything accomplished within government. In other words, it’s just how the business of governing our country gets done in DC. The FDA oversees 25% of all consumer purchases in this country (food and drugs are a trillion dollar a year economy) and Dr. Hamburg surely knows she needs all the good will on Capital Hill to adequately fund her plans for the FDA. Being a hero – to Jerry’s kids at the MDA no less! – burnishes her image and with the upcoming budget battle for scarce Federal dollars you can bet that Dr. Hamburg will position herself accordingly in the eyes of public opinion.

When the photo ops of the March 12th meeting take place, one needs to evaluate whether or not Wall Street will be as skeptical as it appears to be with the stock in the high 20s. I think the relatively low volatility in the in-the-money March calls are a good way to take a flyer on Wall Street being pleasantly surprised by the FDA’s acceptance of eteplirsen.

Longer term, I think the value in Sarepta is enormous. Perhaps in a future piece it would be worth laying out the case for why the FDA will ultimately approve Sarepta’s drug platform as a basis to rapidly churn out treatments for the other exon-mutation  classes of DMD patients. Sarepta already has treatments for exon 45, 50 & 53 in pre-clinical development.

But for now the attention should focus on eteplirsen alone. Lazard pegs the opportunity for exon-51 as being worth anywhere from $83 to $139 a share. I don’t doubt it. Wall Street values the legislatively-protected cash flow from orphan drugs very highly – just look at the multiple Sanofi paid for Genzyme – and Sarepta could have a similarly rosy future.

Immediately after the release of the positive Phase II data Sarepta’s stock traded in the mid 40s before sliding all the way down to where the company raised money at $25.25. Since the company is so well funded I don’t expect a similar meltdown post-AA rather I expect the market to begin to consider the value to Sarepta upon approval as well as the significant European potential for the drug. My best guess is that the stock retests its’ 52-week high of $45, with the price climbing into the decision once the drumbeats within and without the FDA begin to be heard.

At the time of this report the author was long Sarepta common stock and call options

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Update : I posted an updated companion piece on Friday March 8th, 2013.

You can find the link to the piece entitled “Profiting on the Possibility That the FDA Has Turned a New Leaf”  here : http://www.littlebear.us/?p=662

I didn’t notice any Windows Phones being displayed so I asked one of the Verizon reps where they were. The nice young Verizon lady sheepishly explained to me that there were none on display, but expected the corporate marketing team to bring them in shortly. It appeared my question was the number one request people were making of her that night, and she looked embarrassed to admit no one in corporate had thought to display these new shiny Microsoft gadgets so soon after the launch last week.

My experience last night was no outlier. I had a chance to speak for 30 minutes with a good friend of mine in the legal profession. With Verizon carrying the  HTC 8X, the low-cost Nokia Lumia 822 and the soon-to-be-released Samsung Odyssey, you now have three solid Windows Phone choices to choose from. In his expert opinion people who are heavy users of Word and Excel files will, over time, gravitate towards the Windows platform as the phone of choice. You can’t compare the experience of flipping through a spreadsheet on, say the HTC 8X, with using one of the downloadable iPhone apps such as Documents to Go.

Consensus has traditionally been that Microsoft is a lumbering, clumsy giant when it comes to barging its’ way into new markets. The original Windows Phone 7.0 platform for smartphones, launched November 2010, was an utter flop, perhaps even worse that the ancient CE platform rollout. After cutting a deal with Nokia in February 2011 to bring some much needed handheld experience and going back to drawing board – along with some highly publicized apologies from top Microsoft brass - the conventional wisdom was that Windows Phone 8 was going to be yet another flop.

Boy does it look like Steve Ballmer is going to prove the skeptics wrong.

I’m hearing anecdotals from contacts of mine of people who are considering returning newly-bought iPhone 5s in order to switch into the Odyssey and HTC Windows phones. I’m seeing people at the few Verizon stores that carry the phone get bombarded with additional questions from interested customers wanting to know when the Windows App store might start to look more like Apple and Google’s. And I’m seeing a fair number of corporations with large Word & Excel deployments seriously consider the Windows Phone architecture as something to rollout in the coming quarters.

In short, while Apple’s market position isn’t at risk, I don’t see the landscape getting worse for Microsoft anymore. I think this time next year we’ll be talking about the Windows Phone platform garnering 5-10%+ US N.A. market share. Currently Microsoft’s mobile market share is hovering above the 1% mark.

At $27 and change Microsoft’s valuation is almost entirely derived from its desktop operating system and Word cash cows. There is little to no value being placed on the company’s future in mobile. My guess is, that’s about to change, and in a big way.

Headlines that are reporting the death of Microsoft in a wireless world are, in the words of Mark Twain, greatly exaggerated. Be prepared, as I like to say, to be surprised to the upside.

At the time of publication of this report, I am long Microsoft 

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With so much time passing, FXEN should have been able to core and reach the rotleigend by now. Associates of mine have been to the drill site and have reported that coring and/or drilling have been taking place almost every day for the past two weeks; from what we know from the August 20th press release, there has been more than enough time for such coring to reach the rotleigend and discover once and for all whether the formation is gas-bearing.

So it was very interesting to find out yesterday morning that FXEN had apparently strung up casing on the rig. (You can view a photo from the site taken yesterday afternoon with this link ) Approximately 24 hours later most of the casing had been inserted into the well. (You can view a photo from the site taken today at 4pm local time with this link. I apologize for the poor Polish weather gumming up the lens!)

Why would FXEN be casing the rotleigend (assuming that is what they are doing) right after coring into it? Considering that FXEN has been coring, by now the rock samples would have been analysed for porosity and permeability. They would have known if the formation contained gas or -gulp!- salt water. There would be no reason I could think of to case a well that contained salt water. Therefore, one could make the logical assumption that if they are truly casing the rotleigend then FXEN believes there is something behind the pipe worth protecting.

Why wouldn’t FXEN have performed a quick drill stem test (as FXEN had previously done with the Kromolice-2 for example) and flare the well? I can’t answer that. However, upon spotting gas shows at the most recent well, the Komorze-3K, FXEN’s partner and well operator PGNiC decided to forgo doing a drill stem test and went directly to running a full production test. Is the fact that FXEN is setting casing at the Kutno-2 a sign that they are completing the well and going straight to a production test?

There seems to be a lot of unanswered questions. At this point you can draw your own conclusion as to the eventual outcome. With the stock at close to $8 there is ample opportunity for any nervous shareholders to sell. But to my untrained mind, it seems that FXEN’s apparent decision to set casing at, near or below total depth is a positive one. If I am right about that, shareholders, not sellers, will be the ones ultmately rewarded.

If anyone amoungst my readers has a strong opinion one way or the other please don’t hesitate to email me.

Disclosure : At the time of the publication of this report, I am long FX Energy common stock and call options.

Disclosure #2 : FX Energy is an extremely volatile small-cap equity, and as such an investment in FX Energy is ONLY suitable for investors with a strong tolerance for risk.

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Addendum 9/14/2012 

Recently there have been a number of postings commenting on this piece on various financial message boards. The comments broadly cover two topics : 1) the photos I attached to this story look fake, and 2) the pipes shown in the photos look more like drill stem than casing.

The first issue was quite amusing to me. If you have been reading my blog for the past year you know the depth at which I cover special situations. To think that I would doctor photographs is laughable. Furthermore, even if you don’t know me or my work, it would be foolish to think I would do something that could be proven false in a second – anyone who has been to the Kutno-2 site in the past two months knows what it looks like!

I do, however, have to apologize for the grainy look of the photographs. The drill site has a full complement of security staff, and while my associates were very careful not to tresspass, I didn’t want to have anyone taking photographs from the public roads in plain site as that might antagonize someone. Therefore, my photographs were taken over time by a webcam established approximately 200 meters from the drill site, on private land leased by me, sitting on a server that is accessable remotely by me.

Addressing the second question : When I visited the site personally in early to mid August I observed the casing of the Zechstein. I also observed pictures taken by my webcam of what I believed to be drill stem used in late August and early September to core into the Rotleigend. I certainly observed the drill itself used in the coring. To my untrained eyes the pipe used recently appears to look very similar to the pipe used to set casing at the Zechstein. However, since I am not working on the rig and have no access to information other than what is observed by me and my associates near the Kutno-2, I cannot state with 100% certaintly that FX Energy is lining the Rotleigend. That is why I couched my piece in the type of uncertain language that I used, as well as asking for comments from my audience at large.

I continue to have associates on the ground near the Kutno-2 site as well as access to the webcam, and will share important updates from them with my readers on my twitter feed. While I remain optimistic with the chances of sucess at Kutno, I want to again stress that an investment in FX Energy entails an enormous amount of risk and that my readers should carefully consider whether a position in FX Energy is at all suitable for you given one’s investment posture.

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Addendum 9/21/2012

As is typical for a name I publish on, my inbox is swelling with emails from readers asking me if I know the reason for FXEN’s recent swoon. I know the stock is sitting in weak hands when people come out of the woodwork and start to worry when the stock is down 30 odd cents. But yesterday and today’s move is completely predictable. Here’s why :

As of the close yesterday, the September call options had the following open interest :

Sept 7 1/2 = 2,387

Sept 10 = 7,208

Sept 12 1/2 = 1,390

All of those call options are owned by people who are essentially gambling on the outcome of the Kutno-2 well (ignore for a moment the minority of holders who are in those derivatives as part of a hedging strategy; writing this blog allows me to gauge my readership and I know by seeing my email traffic that very few call holders are hedgies. Besides the volume of the stock is such that it doesn’t attract those kinds of players by and large) and like most of us, we thought the news would have been out by now.

All of these calls are expiring today. Now that’s bad for the call owners. But its also not good for the option market maker who is most likely on the other side of most of those contracts. That’s because these call sellers needed to buy common stock when they first sold the calls to the speculators, and they bought stock in some ratio. Call sellers own stock to hedge the risk that the option they are short goes up as the stock goes up and they then need to make good on those calls. Now that the liability (ie. the short call) is going away, these market makers need to liquidate the stock they bought in the first place.

All of the above is B-School Equity Options 101. But what makes FXEN interesting here is because so many calls are outstanding relative to the daily volume that the option market makers can’t sell the common stock near the close of trading today, like they normally would for a heavily traded option name like Apple. Instead, they slice up their order and execute it over many hours. In the case of FX Energy there is so many shares to be sold relative to daily volume that it appears to me they started selling yesterday.

Other shareholders see the volume come into the name, get nervous, and start to lighten up. It’s a classic trading pattern I’ve seen dozens of times on highly controversial “binary event” type names. The call sellers could actually end up losing money as they sell the hedged out stock into a falling market. The 30, 40 or 50 cents they once pocketed as premium for the call sold ends up getting eaten away by the decline in the stock price.

Now option sellers don’t need to own stock on a 1:1 ratio. Instead they follow a formula that constantly adjusts the holding of stock relative to how close the stock price is to the strike price. In the case of FXEN, I’d say there is probably 250,000 shares for sale today, and the stock price will have to get much lower than $8 for all those shares to find a comfortable home.

The situation is further compounded by the fact that the company is speaking Monday. If you are already a shareholder, why buy today in front of that event? Why not wait until the dust settles, see what additional information has been released if any, and make your buys then.

All of the above is fertile ground for a slow meltdown. As a bull on the name, its a great opportunity to buy stock for a short term trade if you believe the fair value of the name is higher than where it is now. I lightened up my position in the last few days to prepare for this pre-option expiration selloff.

Is it possible that someone knows something negative about Kutno-2? Always a possiblity. But what are the odds that happened just as the market makers geared up for some serious selling? Not likely. Guess I’ll take my chances.

Therefore, as the call sellers liquidate, I’ll be buying. Unless we get bad news over the weekend, these should turn out to be good buys. Guess we’ll just have to see what Monday brings!

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Spaniards hold the dubious distinction for participating in the largest yearly lottery drawing, the Lotería de Navidad. With a history stretching back to 1812, it is estimated some 97% of the country’s population participate in purchasing millions of tickets with a face value of 200 euroes apiece (most people purchase fractional interests for 20 euro, called  ”décimos” ).

All of Spain becomes transfixed for a three hour period in December when students of the country’s oldest school draw the 1,787 wooden balls to determine the winners of the lottery. The drawing is broadcast nationwide on television and most radio stations break in with frequent updates.

Total prizes in the drawing make up approximately 70% of the face value of the tickets sold, which for the past few years has been exceeding 2.5 billion euros. The top prize is called the “El Gordo“, which in 2010 consisted of approx. 500 million euros split amongst more than 100 people.

I don’t recommend investing in lotteries. I’m squarely in the investing, not gambling camp. However, every once in a while the stock market gives you the chance to buy a lottery ticket at a price even investors like myself can’t afford to pass up – $0.

The free lottery ticket in question is the common stock of FX Energy (Nasdaq: FXEN). FXEN is a small, off-the-radar gas producer focused almost exclusively in Poland. In approximately 45 days shareholders of FXEN will get to participate in a lottery drawing taking place 1,700 miles to the east of the El Gordo, a few miles outside the small, bucolic town of Kutno, Poland. And unlike the chances of winning the El Gordo, the risk-adjusted payoff per ticket will make this lottery drawing one of the greatest wagers the European continent has ever seen.

Sound absurd? After spending more than a month on this story, I’m convinced of this. It’s now apparent to me that only a handful of people know this drawing is even taking place –  that hidden within the folds of this $7 and change OTC name is the near-term potential to earn $20, $30, or even $40 a share. It is precisely because this fact is known by so few traders, that the cost to take the gamble is essentially zero after factoring in FXEN’s proven existing gas reserves.

Background

In 1989 Poland moved peacefully from communism to democracy and quickly adopted a number of pro-business, pro-growth policies. Along those lines, In 1995 the government approved a privatization and restructing program covering the entire Polish petroleum sector. These moves opened the way for Western oil & gas companies to enter the exploration, production and related service industries.

FXEN was one of the first foreign companies to do so. Using its first mover advantage, the company locked up the development rights to millions of acres of onshore blocks. It then embarked on an aggressive 2-D & 3-D seismic shoot of the most promising prospects. Starting in 2000, it began drilling some of these prospects. Partnering with PGNiG, the Polish Oil & Gas company de-nationalized in the 1995 legislation, FXEN first developed the Fences concession, hitting 8 out of 11 wells targeting Rotligend structural traps. These discoveries averaged 17 Bcf net to FXEN, with each well adding over $65 million in pre-tax PV10 reserve value (with a net cost of around $ 5m per Fences well, the FXEN drilling program was highly accretive!)

The reserve valuations are higher than what you would expect a US-based gas company to generate from the same sized reservoirs. This is because the European gas market clears at significantly higher prices than the US. Poland imports more than 65% of its’ gas needs from Gazprom, a Russian-government controlled entity. Gazprom exports to numerous European countries as well, and in competition with other buyers, Poland pays a market price in excess of $10/mcf. The market price for domestically produced natural gas is set by the government, at a slight discount to the Russian supplies. Prices are set approx. twice a year and are currently in the mid $8/mcf. European gas supply in general is very tight, with the continent relying on the Russians for half of their supply, a situation that is unlikely to change anytime soon. LNG imports are too small to shift the balance, and therefore with the continent in the grip of the Russians the risk to FXEN that natural gas pricing will collapse in the short term is extremely low.

Existing Production

After a fitful start in the early 2000s, FXEN is now solidy in the black. In 2012 the company is on track to generate in excess of $35 million in revenues. Labor and operating costs are relatively low in Poland, generating outsized profit margins on production. Well production costs are much less than in the US (running about $0.50/mcf) and royalties clock in at a measly 1%. If you include D&A (the costs of finding the gas and building out production facilities) a Polish well throws off excess cash above $1.25/mcf and actually turns a net profit above $4/mcf; the current market price is over twice that figure. Based upon current trends, FXEN should exit the year with about 18M mcf/day, which comprises slightly less than 5% of Poland’s entire daily natural gas production. So while the market cap seems small, as far as Poland is concerned FXEN is a well-regarded important player in a domestic energy industry that needs to wean the country off Russian gas.

Buried on page 14 of FXEN’s June presentation you can see just how the company has methodically built out its gas reserves over the past 8 years. Before accounting for any value towards its undrilled acrage, FXEN has conservatively booked $5.46/share in  gas reserves (in E&P jargon, its P50 (1P + 2P) value). Almost all of this value comes from a handful of wells drilled in the Fences concession – leaving an enormous amount of upside still to be discovered amoungst FXEN’s millions of additional acreage.

A few days ago FXEN announced better than expected results at a well it was drilling near the highly-succesful Lisewo-1. Known as the Kormoze-3K, it is a well-defined 3d seismic target that now looks to hold more gas than the Lisewo-1 itself. There are four more similarly situated 3-d defined traps nearby. Extrapolating the success of the Kormoze-3K to these four additional prospects gives me an additional $3-4/share in future gas reserves.

It’s my strong opinion that a purchaser of FXEN stock today is buying in-ground European gas reserves at a discount, with the 3m+ acres of future development coming along for free. And all that is before one calculates the optionality value of the Kutno Prospect, a wildcat operation that could literally change the energy profile of the country itself.

Kutno

In 2007 & 2008, FXEN picked up on the cheap three onshore blocks (Block 2/2007/p, 53/2008/p & 62/2008/p)  in the center of the country, which together covers an area of 706,000 acres west of the capital Warsaw. Very little drilling had been done on these blocks in the past. The only significant well was the Kutno-1, drilled in 1983 by the Soviet-era predecessor to PGNiG. The Kutno-1 targeted an extremely deep & large prospect in the Rotliegend (an early Permian basin sand that forms the basis for much of the oil & gas reservoirs drilled in the North Sea) that sits underneath a well-defined Zechstein salt layer. After drilling for more than two years, the well was abandoned 200m above the Rotliegend objective when the drill pipe got stuck in a salt ‘pillow’.

The Kutno Prospect was the only deep exploratory drilling performed on the blocks. All other wells drilled in the region were shallow stratigraphic wells. There were two ‘scientific’ wells that were drilled in the mid 1980s by the Polish Geological Institute that reached the Carboniferous layer (The Carboniferous sits below the Rotleigend) which both had gas shows – confirming that the Carboniferous could act as a secondary reservoir for the Kutno Prospect (the main target being the aforementioned Rotleigend sands). If you are like me and not steeped in geology I recommend reading the Wikipedia articles on the Rotleigend Sand, the Zechstein layer and the Carboniferous.

In October of 2010, FXEN signed an agreement with PGNiG to jointly fund an attempt to drill an exploratory well targeting the original Kutno Prospect. Additional 2-D seismic showed the prospect sitting at a depth of approximately 6,000 meters (or 19,000 feet). The Rotleigend had never been drilled within Poland to that depth, and it took many months to find a driller willing to undertake the assignment for a fixed fee (capping FXEN’s financial exposure). After negotiating a $20m budget with NAFTA Pila, the well spud in August of 2011.

What makes the Kutno Prospect a worthwhile gamble of $20 million dollars is the sheer size of the targeted structure. Extensive seismic studies done on the block suggest a possible 15-20 Tcf (trillion cubic feet of gas, using an estimated porosity of 10% and permeability of approx. 10 mD) sitting within a 35,000 acre mega-structure. This target is a well-defined four-way dip closure that covers over 140 square kilometers. At that size, the Kutno Prospect is the largest mega-structure currently identified in all of Europe that remains undrilled.

The Lottery Drawing

At 19,000 feet, drilling the Kutno-2 has not been an easy task. FXEN first guided investors to expect results months ago. Along the way numerous technical and mechanical difficulties have slowed down the drilling to the point that investors had almost given up hope. Two months ago the Kutno-2 was more than 6,000 feet from TD (total depth) and the stock briefly broke $5/share.

However, in the past 45 days NAFTA Pila has drilled through the most difficult part of the well and has been making steady progress towards reaching TD. The last 4000 feet or so is all Zechstein salt, relatively easy to drill through. Since early July FXEN has issued 3 updates on the progress of drilling Kutno-2  (July 11th, July 24th and August 6th) and it has become increasingly clear that within four to five weeks FXEN should be in a position to test the well for the presence of gas.

Let me underscore what is at stake in Kutno-2. If the prospect is shown to contain gas at a porosity level that makes it commercially viable (anything above 6% would most likely do – its important to note that the closest analogue to the West, the Fences concession, contain gas reserves in excess of 20% porosity) a 50% ownership stake of a field this size would have a present value in the many billions of dollars. With less than 60 million shares outstanding – well, you do the math.

Investors are Yawning

Historically, the stock market sits up and takes notice of potential game-changing future news flow through the option market pricing of volatility. Equity options (calls and puts) are usually priced off of historical volatility. In short, if a stock has gone up or down 75% in a given year, option pricing would use such historical information and price at-the-money and out-of-the-money calls and puts using an IV (implied volatility)  around 75. When companies approach an inflection point (the best examples are biotech companies approaching a FDA decision date and companies immediately before reporting quarterly earnings) the IV climbs higher than historical values, as market makers require buyers to pay more for the priviledge of betting on a future large move in the stock price.

Up until recently, the IV spread for FXEN call options compared to the stock’s historical volatility has been low. The only conclusion I could come to was that the market was skeptical that FXEN would ever complete the Kutno-2 in a reasonable time frame. Some of the ‘Kutno skeptics’ might have been afraid to dabble in near-term options, lest the drilling take longer than expected and the options end up being worthless.

Currently the IV for FXEN 60-90 days out stand at 80-85%. Historically FXEN has a volatility of 45-60%. Although current options are priced slightly higher than historical volatility, the premium, in my opinion, is still too low.

Conclusion

I don’t advocate individual investors buy equity options as a matter of course. Buying options is a risky investment and there is a strong likelihood of losing all your money. Don’t argue with me on this – it’s a fact.

However – It’s my strong belief that the hardest part of drilling Kutno-2 is behind FXEN and in the next 30-45 days the market will know whether or not the target structure contains gas. In short, the lottery drawing will take place sometime in September. I think the at-the-money and out-of-the-money call options on FXEN are almost completely ignoring the potential sharp move upwards should Kutno-2 hit paydirt. At these prices – you’re almost being paid to buy a ticket

Based upon the open interest, I have most likely purchased the largest stake of any single account in FXEN’s December call options. I think the September options could also be bought - but I am not as convinced that the risk of delay in finishing the well is worth the price differential between the September and December options. If you want to buy a lottery ticket that could pay off why take a chance of missing out on the drawing by a matter of days?

For the vast majority of investors the options should be no more than a curiousity. The common stock of FXEN is a great risk/reward trade going into the Kutno well results – unless of course the market takes the stock significantly higher between now and then.

The bottom line is that FXEN is poised to report the results of what could be Poland’s most successful natural gas discovery in the past 60 years. At the end of the day I have no clue whether or not the Kutno Prospect holds gas, but I do know that this is one lottery drawing whose payout is stacked in my favor.

Disclosure : At the time of the publication of this report, I am long FX Energy common stock and call options

Disclosure #2 : FX Energy reports tonight; although I do not expect the financials to mean much in the face of the impending Kutno news, please be aware that historically the common stock of FXEN exhibits higher than normal volatility after earnings.

Harvest is an independant energy company with exploration programs in Oman, Indonesia & Gabon. While those projects may or may not pan out, Harvest has the vast majority of its existing capital tied up in a 32% stake of PetroDelta, a large Venezuelan oil producer currently pumping out over 31,000 barrels a day near the prolific Orinoco / Faja heavy oil belt (The Venezuelan government indirectly owns a majority 60% stake).

On March 6th of this year Harvest dropped a bombshell : A few days earlier it had entered into exclusive negotiations with a third party for the sale of Harvest’s entire stake in PetroDelta. The most recent audited, present value analysis of the proved plus probable oil reserves at PetroDelta puts the value at over $1.05 billion. Throw in the possible (3P) reserves – in the Orinoco belt possible oil reserves are almost always bankable – and you get an additional $860 million of value.

With approximately 37 and a half million shares outstanding (adjusted for a recent debt conversion) and the stock changing hands for $6 an change, something is clearly amiss. The market price is telling you that either (a) management is on the verge of selling PetroDelta at a price far far less than its intrinsic value, or (b) chances of any sale are slim to none given the Venezuelan’s propensity towards injuring its’ US-based oil investors.

It’s my belief that both risks are extremely overblown, and that a rational investor will rejoice at the opportunity to participate in the extreme upside / limited downside that currently exists in the common stock of HNR. In fact, if I’m right about this, Harvest’s stock could easily double in a short period of time as a possible sale moves forward. Here’s why :

The History of PetroDelta

The story of how this US-listed small-cap oil company got into bed with the Venezuelan national oil company PDVSA is a fascinating one and worth, for the uninitiated, reviewing . Harvest has been operating in Venezuela since 1992, when it signed a 20 year operating agreement with an affiliate of PDVSA to develop the Uracoa, Tucupita and Bombal fields. These three Orinoco belt fields were developed from 1937 through 1962 and abandoned in 1987 (when oil prices averaged $17.75 a barrel). Harvest’s pitch to the Venezuelans – let us come in with American technology and know how, and get the cost of the production down and throughout up such that the fields could be produced at a profit. The pitch was persuasive; or else at an average crude price of $19.25 ($31 in inflation adjusted dollars) that year there wasn’t much competition. Either way, Harvest ended up becoming the first American company since 1976 to be granted an oil field development contract in Venezuela.

The agreement called for the Venezuelan government to maintain full ownership of all hydrocarbons in the fields, as well as the equipment and capital infrastructure. Harvest received an operating fee for each barrel of crude oil delivered, as well as getting reimbursed for most of its capital expenditures.

Things worked well for a decade. When oil prices jumped 50% from 2002 – 2004 (going from an average of $22.81 to $37.66) Harvest’s stock price jumped from around $4 to over $15 as oil production from these once-barren fields gushed to 28,000 barrels a day. But with the rise to power of Hugo Chavez the good times were about to end.

In early 2005, PDVSA began to disapprove of Harvest’s capital budgets (PDVSA approval was a necessary component for all foreign operators in Venezuela looking to recoup their expenditures exclusive of the operating fee). At first this was odd to Harvest given the success they had in increasing production. Without certainty on what to spend in drilling new wells, Harvest’s production naturally declined over the year to 22,000 barrels a day.

It seemed very odd that the Venezuelans would want to throw a moneky wrench into production that generated substantial revenues for the government. But within months, it became perfectly clear what Chavez was up to – namely to nationalize the industry and whack the ‘obscene’ (in Socialist-speak) profits being generated by American gringos.

PDVSA proposed that, in place of the existing operating agreement, the three fields would be placed into a joint operating company (“JV”) to be owned 60% by PDVSA. Harvest would need to completely waive its operating fee, and instead be compensated through dividends declared by the JV. Along with bumping up the local income taxes from 34% to 50% (applied retroactively for a number of years!) the net effect was to steal a significant percentage of the net present value of the Uracoa, Tucupita and Bombal fields in the name of the Venezuelan people.

Under threats to have all three fields taken away unilaterally, Harvest attempted to hammer out an operating agreement for the new JV (ultimately named PetroDelta) while in a parallel action threatening to litigate the ‘theft’ of its existing license in international court. Harvest spent much of 2005 & 2006 threatening such litigation while hammering out an improvement to the structure of PetroDelta that would partially compensate Harvest for its losses in the nationalization.

Harvest wasn’t the only company effected by this nationalization attempt. Eighteen other international oil companies operating in Venezuela were given the same ultimatum. Exxon and Conoco balked at the terms, sued in international court (Exxon alone demanded $12 billion; after a 5 year legal slugfest they were recently awarded a paltry $255m, retroactively validating the decision by the management of Harvest to negotiate a better JV agreement in the first place) while the rest knuckled under and signed new agreements converting old operating service agreements to new majority PDVSA-owned mixed operating JVs.

After an extended set of negotiations, which included the intervention of the Venezuelan ambassador to the United States, the Venezuelan Ministry of Energy and Petroleum (“MEP”) offered up a sweetener to Harvest in exchange for voluntarily agreeing to contribute its rights to operate the three fields to the newly-formed PetroDelta. MEP agreed to transfer to PetroDelta the exclusive rights to three new oil fields, the Isleño, Temblador and El Salto fields (A link to a useful map of the fields can be found here). These new fields were located in the same geographic area as the first three and seem to share the same geology and productive formations. Also like the first three, Isleño, Temblador and El Salto had undergone minimal development in the past and would require Harvest’s expertise to develop a drilling program suitable for its’ particular geology.

In September 2007 Harvest and Venezuelan government signed all the necessary agreements and PetroDelta came into being. So in short, while Harvest gave up a lucrative cash flow business from operating its existing 3 fields, the company played ball with the nationalist crowd in Venezuela and picked up a 32% interest in 3 additional fields for its trouble.

PetroDelta ended 2007 producing 13,100/bopd due to the lack of capital investment over the prior two years. With Harvest back in charge and on the ground agressively drilling new wells, production steadily increased to 20,000/bopd in 2008. More importantly, Harvest drilled its first two wells in the Temblador Field (one of the three additional fields granted to PetroDelta) and both initially produced (“IP”) in excess of 2,000 bopd. Clearly Harvest had chosen its new fields well.

With the increase in production, relations with PDVSA improved. The Board of PetroDelta began declaring dividends of its’ excess cash (there was enough profit at existing oil prices for PetroDelta to internally fund its drilling program with excess cash flow) and by 2010 production inched up to 24,000 bopd while the Proved reserves (“P1″)  net to Harvest in Venezuela increased to 50.0 MMBOE and Probable reserves (“P2″) climbed to 103.6 MMBOE. On a net present value pre-tax, proved plus probable reserves had an audited value (discounted at 10%) of over $2.3 billion dollars.

In 2011 production at PetroDelta continued to improve; however relations with PDVSA turned cold. In April the Venezuelan government approved a new round of ‘windfall’ taxes. The tax on revenue was pegged to the price of oil, and called for companies operating in Venezuela to hand over 80% of revenue above$70/bbl, 90% when prices rise above $90, and 95% above $100/bbl. This confiscatory policy had the effect pitching the excess acash flow necessary to both pay dividends and fund a robust drilling program. Opting for the latter, PDVSA declined to pay Harvest its’ share of previously stated dividends and diverted what cash it could to a 2-drilling rig program with 2 more coming on in late 2011.  In spite of the financial difficulties, the fields continue to outperform, and both Temblador and El Salto saw new wells IP at approx. 3,200 BOPD; these were the highest IP rates recorded by Harvest since the beginning of the 2008 drilling program. But without access to its profits, Harvest shares tumbled, eventually bottoming out at $6 and change in Dec ’11 / Jan ’12.

Throughout the Chavez-induced difficulties Harvest has gone through, there has been a number of opportunistic buyers that approached the company regarding a bid for PetroDelta. Management has stated numerous times that the PetroDelta asset has significant value and would not be sold in a “fire-side” sale. These comments were not made without good reason; according to one source of mine, some time last year a Canadian firm made an informal offer in the mid-200 million dollar range for the asset only to be rebuffed by management without further discussion.

Harvest’s Other Assets

PetroDelta is the crown jewel of Harvest, but it does own a slate of international development projects. In the last 12 months Harvest has turned up disappointing drilling results in Oman and Indonesia. However, Harvest does own a 66.667% of an offshore block in Gabon, called the Dussafu PSC. The Dussafu is located in a few hundred feet of water, and is South East of the well known Etame field, operated with much success by Little Bear favorite Vaalco Energy (NYSE: EGY).

Appraisal well activity, completed in 2011, has shown positive results. To date Harvest has made three oil discoveries in the block, totalling an estimated (gross unrisked) 26 million barrels of oil. While nowhere near the opportunity of other off-shore African finds, this block does has significant value. Pritchard E&P analyst John Abbott, whom I think does the best work on this name, pegged the value of the Dussafu PSC at $3/share. Given that the structures of the three finds are direct analogues to the existing Vaalco Etame production its a good bet that value exists.

Harvest recently sold a large portfolio of US assets and paid down virtually all its’ debt with the proceeds. After doing so Harvest has approximately $1.50/share in cash, after adjusting for ongoing overhead and existing payables.

Who Would Want to Buy INTO Venezuelan Oil?

The market is clearly skeptical that Harvest could find a buyer with the necessary patience, never mind deep pockets, to take a 9 figure gamble on buying a minority stake in a Venezuelan oil company in the grips of Chavez’ socialist-stealing hoodlums. Under normal circumstances, no large cap oil company would throw its shareholder’s wealth at such a gamble. But there is one set of buyers eager to do business with Chavez : the Chinese.

Pushed into locking up oil supplies worldwide to feed a domestic demand for crude that has already topped 10 million barrels a day, China has spent a good part of the last decade investing large sums of money abroad in emerging oil fields. China’s strategy can be summed up rather simply – find cash poor, resource rich countries on the outs with the West, preferably those with autocratic govenments, and offer cash on the barrel in exchange for long term supply agreements. China agrees to turn a blind eye to any human rights ‘issues’, couldn’t care less how onerous the socialist tax regime is, and doesn’t worry about any anti-bribery niceties such as the US’ Foreign Corrupt Practices Act. The number one goal is to secure long term access to oil, preferably in places that the West can’t interfere with.

China has pulled off its oil land grab with remarkable success. The results have been most spectacular in five countries where Chinese state-owned firms deployed the majority of their cash : Sudan, Kazakhstan, Angola, Iran, and of course, Venezuela. (A full review of the Chinese invstment in the overseas energy industry is beyond the scope of this article. If the reader is interested in exploring this admittedly fascinating subject, the easiest and best way to go about it is to read this 52 page report by the IEA written in February of last year.)

In the past two years, Chinese state-owned companies have signed in excess of $14 billion in various development and long-term purchasing deals with PDVSA affiliated entities. It’s not as if the Venezuelans had much of a choice; the existing operators are loathe to commit additional capital to a country that steals, uh, taxes 80-90% of your revenue. Without new investment, existing wells mature and decline, and as such overall production has been declining over the past few years to where current output is around 2 million barrels a day. For a country estimated to possess anywhere from 100 billion to 900 billion barrels of oil this is nothing short of an embarrassment.

In my discussions with a number of industry contacts close to the situation both inside Venezuela and in the US, the two oil companies most frequently bandied about as being the likely acquiror for PetroDelta are Sinopec and CNOOC. Both oil companies are significantly state-owned and have invested tens of billions of dollars in securing oil deposits overseas. Just recently Sinopec agreed to invest billions to develop the Orinoco Junin 1 and Junin 8 blocks, which could each produce up to 200,000 barrels a day of crude. CNOOC has also been active, signing a number of joint venture agreements with PDVSA to develop various new fields within the Orinoco belt. At every turn, officials at PDVSA and both Chinese companies have made it clear that existing deals are only the beginning as all parties intend to work even more closely developing the multi-billion barrel opportunities that abound in the Orinoco.

What is PetroDelta REALLY Worth to the Chinese?

A number of analysts I spoke to who follow Harvest say that the convential wisdom amounst oil & gas investors is that Harvest could reap $200-$300 million in any sale. Most observors of Harvest get this number by looking solely at the 1P value – namely the proven oil reserves from wells already in production, and ignore everything else. Harvest has 38.6 million barrels of proven oil attributable to its share of PetroDelta and at $6-7 per barrel you get a 200-300 million dollar range. Even the bulls at this  point would be happy with such proceeds, as the entire market capitalization of Harvest is under $300 million – and that’s before adding in the value of Gabon and existing cash reserves.

I think its highly unlikely management would go through the legnthy process of selling an asset it has developed over 20 years for solely its 1P value. In fact, in a telling exchange I had with James Edmiston, CEO of Harvest, on the latest conference call March 15th, he said exactly that (a link to the transcript can be found here)

Zachary Prensky : I think what would be helpful, (…)

is to give us a little more color as to what metric

 you find the most compellinginternally as you strike your own

 valuation on the Petrodelta asset.What I mean is, (you said) there will

be no fire sale of the asset (….)  But as you define

a fireside sale, what is the single-most important metric

that you look at, at valuing it, and then comparing your own internal

valuation to what you would accept in the sale process?

James Edmiston : What I can point to, though, what I’m allowed to point to are

 things like the reserve report where the after-tax PV-10 in the reserve report this year

for the 2 PKs is a little over $1 billion for the one, a little over $1 billion.

So it’s a pretty big chunk of money.The other thing you can point to is just

classical metrics, I guess. I mean, in the last year I believe Steve pointed

 out we had $57.7 million in earnings from Petrodelta at the Petrodelta level.

So, you’d have to tell me what’s the appropriate multiple

 for a business that grew at 33%, that has a reserve-to-production

ratio of well in excess of 20 (…) to well in excess of 30 if you count the 2P…

So there’s a broad range of metrics you can throw at this thing and obviously

 we have our own internal view (…)

I’ll be honest with you, I don’t think anybody in our business is trading

 on a 1P metric in the first place I know the analysts like to use

1P, and they show it as a metric, but as a buyer and

 a seller of assets, I can’t — nobody does that.

 I think it’s clear from the above exchange that management would never have entered into exclusive negotiations to sell PetroDelta if it didn’t have a range of values closer to the $1.1 billion dollar after-tax PV10 reserve value. Of course they know that the onerous tax regime in Venezuela makes such reserves less valuable. The flip side to that is that the confiscatory tax policy have made it increasingly difficult for anyone without a side deal with Chavez to justify investing fresh capital into drilling wells and growing production. Chavez will not live forever, and if his well-publicised recurring bouts cancer take a turn for the worse then his abilities to steal oil revenue over the long term are limited. PV10 reserve valautions take into acccount a decade or more of production – its important to note that less than 10% of PetroDelta’s six fields have been developed. Put another way, there are thousands of potential low-risk drilling oppotunities to be developed in the coming decades at PetroDelta – fields like these are the ultimate in long lived assets. Its a virtual certainty that at some point in its’ development PetroDelta’s owners will be paying less in confiscatory taxes than it is now (and again, important to note, even with the existing taxes PetroDelta is fully funded in its existing, admittedly low, capital development plan).

My contacts I’ve reached out to say that James Edmiston would take a number around 50% of the PV-10, or a range of $450-$600 million. Before you laugh, remember that such a price tag gives zero value to the 3P, or possible reserves, currently pegged at over 100 millions barrels of oil. And one thing we know about the Orinoco is that possible reserves have a funny habit of becoming probable reserves (remember that at one point not to long ago all six fields were abandoned and thought to be non-commercially relevant)

In fact, you could make the argument that the Chinese have additional non-commercial reasons for locking down PetroDelta, namely to secure long term oil supplies, and they would be more inclined to pay a number closer to PV-10 just for the exclusive rights to buy the oil. But I don’t think you need to get there to come to the conclusion that the Chinese would gladly pay $500 million, 50% of PV-10, 25% of P3, in order to own this underdeveloped asset.

What Would a Sale of PetroDelta Look Like?

As I discussed earlier, Harvest needed to get its’ shareholders to approve the original deal with PDVSA that formed PetroDelta, and under any sale agreement would have to likewise proxy its shareholders for approval to sell the asset. Under its’ agreement with PDVSA (which you can read as part of Harvest’s 2006 proxy, located here. The relevant section is located on page 40) Harvest has the right to solicit offers for its’ ownership stake in PetroDelta. PDVSA has a 30-day right of first refusal, after which Harvest has 180 days to close the sale.

People have a long memory down in Venezuela, and I’m sure there’s more than a few people who remember how Harvest outmaneuvered PDVSA in getting the Isleño, Temblador and El Salto fields thrown into the  PetroDelta JV. I am assuming the socialists in power will want to let the door hit Harvest on the way out, and threatening behind the scenes to drag out any potential deal with the right of first refusal is the best way to go about it. You can be sure any sale will include the obligatory payoff to those in power, most likely by shaving off 10-20 million in the purchase price, with said funds finding there way back into the right pockets. But ultimately its all about dollars and cents; the Chinese have it in spades, and the Venezuelans don’t.

Both the Venezuelan government and PDVSA in particular have been perenially short of funds. Government bond yields are some of the highest in the world outside of Greece (although, interestingly enough, Venezuelan bond prices have recently rallied sharply- is the market sending a signal as to the results of the upcoming elections?). Chavez’s socialism has led to significant budget deficits which have been filled with more and more petrodollars being skimmed off the top of PDVSA and its’ local operators. In recent years the Chinese have offered to fill part of the funding gap by structuring loans-for-oil (again, more deeply discussed in the abovementioned IEA paper, see page 12 in particular). Again, my contacts have led me to believe that any deal to sell Harvest’s stake to a Chinese firm will come alongside additional capital injections into either PDVSA or PetroDelta itself using some variant of loans-for-oil. Some of the additional cash will most likely find its way into increasing the existing  4 rig development crew into a world class drilling plan more appropriate for a set of fields that can easily produce 40, 50 or 60 thousand barrels a day.

However the Chinese and the Venezuelans cut their deal, its clear they both need each other. And absent Chavez out and out stealing Harvest’s stake in PetroDelta, there’s not much to do except pay Harvest off. (One important note is that while Chavez has nationalized the oil industry, anyone who has gone along with the plan and agreed to operate under the rubric of a 60% PDVSA owned joint venture company has been allowed to continue unimpeaded. And why not? Between PDVSA’s cut and the windfall taxes the government ends up with the vast majority of the revenue. Why steal 100 cents when your oil ‘partners’ hand over 85 cents voluntarily?)

In short, if Harvest was going to sell out at the bottom, they would’ve taken one of the lowball offers pitched to them over the past two years. My best guess is that a deal will be worked out as a three way agreement, whereby PDVSA waives its rights of first refusal (Given how strapped they are by the windfall taxes, PDVSA has had difficulties in even paying its vendors) in exchange for the Chinese agreeing to either lend or invest cash to grow production and help PDVSA out with its’ bills. After all, if the Chinese are able to front a few billion dollars in what is essentially pre-paid oil deliveries why shouldn’t the Venzuelan government be pleased to have them as the new owners of Harvest’s minority stake in PetroDelta?

What If I’m Wrong?

Making a binary event bet is always fraught with risk. While my contacts on the ground are optimistic a sale goes through, there is no guarantee of any successful conclusion. In a situation like this, both the risk must be worth the reward and the downside must be limited. I believe both are true in this case.

On the upside equation, again I would refer the reader to John Abbot’s work on Harvest. (Pritchard Capital is a dedicated O&G shop, and in my experience has had a lot of success in covering these names. If you work at a hedge fund, trade and/or invest in the energy space, and don’t have a relationship with Pritchard you are doing yourself a disservice!) In his updated model published on March 19th he gets to approximately 50% of the $1 billion after tax PV-10 for the P1 and P2 reserves – or $15 a share before ascribing any value to the Gabon assets – and as I’ve described above that’s around where I expect management to be a willing seller.

On the downside, if a sale ultimately falls through its hard to see Harvest’s stock going much lower. Remember that Harvest will still own 32% of PetroDelta, and the fortunes of that investment can only improve if either Chavez’ cancer gets worse, or if the market perceives that he will lose the upcoming October 2012 elections. All the opposition parties have rallied around one candidate, former Governor Henrique Capriles Radonski. While I am no expert in Venezuelan politics, when Chavez-friendly outlets such as Pravda admit he may lose the election the race is tighter than it seems on the surface (Also worth noting that Chavez’s Anti-Semitic smears smack as a bit desperate given that Capriles is a highly noted, rosary-wearing Catholic, who headed straight to a Catholic shrine to give thanks after winning the Presidential primaries). And lastly, voters can’t be amused that Chavez seems to fly off to Cuba every other week for radiation treatments – not the best confidence in a leader you are electing to a new six year term.

So, in a way, Harvest is a low-cost option on the future of Chavez. Its clear from the out-of-control violence to the punishing inflation, Venezuela is a Latin America country falling apart with only the cult-of-personality that Chavez maintains keeping his socialistic vision in power. Like taxes, death is certain to end his reign. With PetroDelta self-funding itself in spite of the windfall taxes, and 90% of its’ acrage still undeveloped, the smart money says that its’ Orinoco oil will still be pumping long after Chavez’s heart isn’t. Therefore, I don’t see much downside from here – actually a case could be made that shareholders are better off if the sale falls apart in a few months if Chavez’s numbers in the polls continue to underwhelm.

Conclusion

As someone who focuses most of my time seeking out binary events where the payoff is skewed, I cannot find too many opportunities better than Harvest Natural Resources. I believe the recet weakness in the stock is due to (a) skepticism over Venezuelan politics allowing for a sale of the asset; (b) doubt over management’s resolve at not accepting a low-ball bid; (c) selling from recent holders of the convertible bonds (the company recently saw a $16m tranche of convertible debt exchanged for approx. 3,000,000 shares at $5.56/share, a low enough price to incentivize those sellers to hit the bid); (d) worries over a recent ATM shelf filing (which cannot be sold into the market currently due to the continuing blackout period surrounding the sale process) which, according to a contact of mine that spoke recently to the company, was put in place to give the company financial flexibility should the sale talks collapse.

None of the reasons, in my opinion, for the relative weakness in the stock price, are indicative of the relative merits of a sale of PetroDelta happening. In my mind, the inherent value of this asset is too great for all parties not to find a way forward. For a management team that has operated in Venezuela for over 20 years I simply cannot believe that they are taking a flyer on feeling out a lukewarm buyer. While I certainly do not know anything more than the market does, all my conversations with people heavily involved in the Venezuelan energy sector lead me to believe the talks are for real. And therefore, this is one special situation worth taking a bold gamble on.

At the time of publication of this research, I am long shares of Harvest Natural Resources, Inc. (“HNR”)

I quickly ran the numbers. It was possible that the pre-salt opportunity in Angola mirrored that of offshore Brazil, where finds like the Tupi field where Petrobras (NYSE: PBY) confirmed a multi-billion barrel potential find. Petrobras and others were committing themselves to spending tens of billions of dollars over the next decade to build out these offshore pre-salt fields in what has the potential down the road to rival the current production numbers emanating from the Persian Gulf.

Geologically, most scientists believe that Africa and South America were once connected, and separated over millions of years in a process knows as ‘continental drift’. If true, it is highly possible that the stratospheric finds in offshore Brazil would be ‘mirrored’ in similarly situated West African pre-salt deposits.

What made Cobalt’s stock continue to climb is that Maersk, owner of an adjacent Angolan block, hit big on its’ pre-salt appraisal well. When that news came out in early January, I bought a fairly large stake in Cobalt at around $15.50 and hoped for the best.

As the stock kept creeping up on me, I sold against my long position, first the 17.5 calls and then the 20 calls. Fairly quickly, I was up almost 30%. Wowzers, I told myself. Who knew investing in Angola oil could be so profitable, so quickly? By the time February rolled around, I was fully hedged and called away on my Cobalt stock at $20/share.

What seemed to be such a smart investment turned into a disaster, as I watched Cobalt last Friday announce a mammoth,  1,180 foot “gross continuous oil column” in its Block 21 Cameia-1 appraisal well. The stock closed the night before at $23.90 and promptly opened the next day at $33.98. I watched in horror as all my homework on Cobalt was realized, staring at me on my screen, except I wasn’t participating in the profits one iota. I left the equivalent of a years’ worth of profit pass by without me because I was too myopic in taking the quick money.

Fast forward to this week. I’ve reviewed in depth the maps encompassing the Kwanza Basin, which is the area offshore Angola that both Maersk & Cobalt hit their respective pre-salt targets. Most of the offshore blocks are controlled by large international oil companies such as Conoco Phillips (NYSE: COP) and Total. However,93 miles north from the Cobalt discovery and within the Kwanza basin, sits block 5, owned by a small, well run outfit called Vaalco Energy (NYSE: EGY).

Vaalco was founded in 1985 and brought its first offshore well online in 1992. It began development in Gabon in 1995 with the Etame field permit and started production in 2002. Since then, its daily production, currently running around 4,000 barrels and solidly in the black, has come mainly from its Gabon assets. With cash as of September 2011 of $112m and net property/equipment of $102m, EGY (with 57 million shares outstanding and trading around $7/sh) has more than half its’ value in cash and tangible assets. Throw in the value of its Etame and other Gabon fields, (Vaalco has 7m barrels of proved reserves and plenty more in the probable column) and the current stock price is attractive on the basis of those items alone. But the real kicker that could propel this stock forward in a meaningful way comes from its 40% ownership of Angolan Block 5.

Block 5 is operated by Vaalco and is made up of 5,700 km or 1.4 million acres of offshore drilling opportunities. 12 wells were drilled by prior operators, and 5 of them reported oil and/or oil shows. Two seismic runs were performed, one in 1997 and another in 2008 (both 3D surveys comprising over 1700 sq km) and a number of promising prospects were identified. Of those, one stands out the most : The Loengo Prospect.

Loengo sits at the southern end of the block, is situated in 510′ feet of water, and has an exciting pre-salt prospect. The company estimates a well would cost $35m to drill the 11,000 feet to the pre-salt formation. Over the past year and a half it has struggled to identify a new partner (Norweigen Interoil walked away from its’ 40% stake around 2 years ago) with which to split the drilling costs. Although there are multiple prospects throughout the mammoth 1.4 million acre field, to date no one has stepped forward. But all that has changed now that Cobalt announced the results of Cameia-1.

Industry players I reached out to told me that since Block 5 lies within the Kwanza basin, Vaalco should have little trouble finding a major oil company to step into Interoil’s shoes. I spoke with Vaalco’s CFO, Gregory Hullinger, last night, who reviewed the numbers with me. Drilling costs are estimated at around $35 million, and any new partner would have to pick up a few million of accrued costs as well as a permit/transfer fee to Sonangol (The Angola state oil company, which holds a 20% carried interest in the block) that could range from 3-5 million dollars to something approaching 10-12 million. (Offshore Angolan blocks have jumped in demand overall since the Cameia-1 results with the Angolan government being the immediate beneficiaries.)

Mr. Hullinger confirmed to me that, in concert with what I’ve heard from others, his phone has been “ringing off the hook”. From what I’ve gathered, its probably a 2-5 month process to weed through the inquiries and nail down the terms for bringing on board a new partner. Vaalco has established a data room and put Sonangol on notice that it intends to move forward expeditiously. In fact, it seemed to me after my phone call that a potential hiccup in moving forward would lay with Sonangol not moving fast enough for Vaalco and its’ new partner in approving the deal.

Stephan Berman, an analyst at Pritchard Capital, has, from my vantage point, done the best research on this company (If you are in the hedge fund world and don’t do business with Pritchard you are missing out on some great oil calls).  He downgraded the stock sometime last year due to what he described to me as his “frustration” with the pace of Block 5 development. That is clearly about to change. Even without the excitment surrounding Block 5, Berman has an $8 target on the stock. The potential for Loengo could be anywhere from 10-50 million barrels of oil, and for a company with less than 10 million proven barrels under reserve, this is clearly a game changer for shareholders. As for the entire block, Sonangol themselves estimated that there is a potential 350 million barrels of retrievable oil, and again, that was before Cameia-1.

I’d expect Pritchard and others to pick up the pace of coverage and start highlighting the value inherent in Vaalco over the next few weeks.  The company will report earnings on March 12th and host a conference call on the 13th. Expect management to ‘bang the table’ with regards to Block 5 and highlight its increased value. I also wouldn’t rule out strategic talks with other players. Its an open secret that Vaalco has  evaluated potential mergers in the past year. Vaalco is an offshore driller with a $400 million market cap and its’ really too small over the long haul to continue to build up drilling opportunities without taking risks too large for any one dry hole to sink the company – if it had to fund Loengo by itself it would cost 25% of Vaalco’s cash position. I wouldn’t be surprised based upon the potential size of Loengo and other Block 5 prospects for these talks to turn to an outright sale of Vaalco.

At the current price of $7 and change the value here is too significant to ignore. I’m a buyer of the stock right here, right now, with what I see as a $1 and change of downside. If the Angola pre-salt opportunities continue to develop as the Cameia-1 has, with literally billions of barrels in extractable oil, this slice of West Africa may very well turn out to be the next Persian Gulf (as the decade long built out of Brazilian fields such as the Tupi discovery are rapidly turning out to be). If that is the case, small Vaalco would certainly be in play.

The bottom line here is that Cobalt Energy tacked on over 8 billion in market cap due to the overwhelming success of its Angola drilling to date. At a market cap 1/30th the size of Cobalt, Vaalco’s stock has a long ways to go if Loengo is successful. Over the past few trading days Vaalco has gone from $6 to $7. This train is leaving the station – count me on board.

At the time of publication of this report, I am long Vaalco Energy common stock

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This time around, investors demanded cleaner, easier to follow, publically traded vehicles and Wall Street responded with such plays as Sandridge Permian Trust (NYSE: PER) or Chesapeake Granite Washington Trust (Nasdaq: CHKR), two vehicles where the rules and risks are stacked heavily in the investor’s favor.

Much like the O&G partnership collapse, speculating in Chinese equities almost came to a complete halt earlier last year with the string of collapses that took place within mere months of each other of well known and widely owned stocks.

RINO International. China MediaExpress. China-Biotics. Longtop Financial. It wasn’t too long ago that these names dominated headlines. It was just last April that the New York Times published its front page business section piece entitled “The Audacity of Chinese Frauds”, detailing the absurd lengths Longtop’s management had gone to interfere with Deloitte’s audit of the company’s cash on hand. 

Yet, implausibly enough, in the case of the feverish buyers in Qihoo 360 Technology Co. Ltd. (Nasdaq: QIHU) they have only let a handful of months pass from when the height of the Chinese frauds hit the fan to when these self-styled momentum investors collectively hit the buy button on a multi-billion dollar Chinese internet stock trading at 10 times trailing revenue.

I find the whole shebang extremely fascinating for the following reason. Qihoo is a classic ‘battleground’ stock. To it’s supporters, Qihoo has revolutionised the Internet market in China by using its free anti-virus software to help it catch hundreds of millions of page views per month in ‘home page’ or ‘web-directory’ traffic.  Qihoo describes itself as the 3rd largest Chinese internet company, with a customer base of over 300 million users.

The bears on Qihoo, led by veteran short seller Citron Research, has pointed out numerous holes in the firm’s financials, business model and market share. In a followup, detailed piece published in early December, Citron Research calls Qihoo and out-and-out fraud.

A more recent addition to the debate is Deloitte-Watch, a website apparently devoted to tracking the shadier side of Deloitte’s Chinese auditing arm. It was most likely DW that pushed Deloitte to go the extra distance on auditing Longtop Financial last year, a level of scrutiny that ultimately pushed that fraud into the spotlight with antics described so deliciously in the above-referenced NY Times article.

These types of ‘battleground’ stocks are not unique to China and there are literally dozens of plays at any given time where in-depth research on highly controversial names can bring out the winning side. As an investor and trader one can try to pick apart each competing side’s claim and take a stand on the issue. However, it’s not my intent today to wade through the various claims and counter-claims of each side.

What I do find fascinating in this particular case is the relative odds implied by the current market price of Qihoo’s common stock. Usually, in a battleground name where each side has strong arguments, the stock price in question implies a 30%,40% or 50% of success for each side coming away victorious.  A good example of this is tonight’s Amazon.com earnings release. Speak to the analysts and you’ll come away with the arguments for either a $1b+ topline beat leading to a 10-20 point blowout to the upside, or else a major miss on the operating margins and earnings which would probably get the stock down 15-25 points. Pull up the option chain and you’ll discover highly pumped price tags all up and down the strikes. Bottom line, the options are pricing in a near 50/50 for each side in this battleground earnings play.

Qihoo is different. Given its 10x revenue valuation, hundreds of millions of dollars of insider stock holdings that are now available for sale, and the recent speed bump most Chinese ecommerce names have hit, you’d expect this name to trade somewhere between the $5 price tag the bears have put on it, and the $2-$2.5b valuation that even the most optimistic bulls can get to on a discounted future cash flow analysis.

Yet the stock sits today at $17 and change. With 122 million shares outstanding on a full-diluted basis, ‘Mr. Market’ has apparently decided that the bear case on Qihoo has little to no chance of bearing fruit. (am I the only one who finds it interesting that Qihoo hides the fully diluted count in its cash flow per ADS statement in the company’s earnings release? You can calculate it by dividing the net income by the Diluted earnings per ADS) This, despite the fact that Citron Research has a 10 year track record of uncovering corporate fraud. This, despite the fact that DW’s work on China MediaExpress and Longtop literally changed the outcome of those two corporate audits.

It seems to me that the investor base in Qihoo have all-too quickly forgotten recent history. DW claims it is in possession of a whistle blower interview that, if true, would blow the doors off Qihoo’s legitimacy wide open. Consider this description of these insider allegations:

• Deloitte-Watch has obtained a copy of a detailed interview with an individual associated with Qihoo 360′s sales department who states that the company is inflating revenues by over 40%, and has detailed the existence of “ghost links”on the hao.360.cn web page…
• The interviewee states that Qihoo 360′s homepage traffic peaked some time ago and now is actually falling. ..
• For safety and security of this person, the identity of the interviewee cannot be publicly disclosed. But, a copy of the interview has been sent to your legal department.

Think to yourself for a moment. Is it possible that DW is completely making this up out of whole cloth? More importantly, What are the odds that this whistleblower actually exists?

If Qihoo were any ordinary ‘battleground’ name, this stock would trading somewhere in the midpoint between the two sides. Gun to my head, I’d guess $10,11 or $12 a share. Its an absolute shock to me that with all the accusations flying on this name that the sum total of market participants are giving Qihoo a $2b+ valuation.

Investors have forgotten that China MediaExpress had its’ stock halted when it was $11. Longtop’s final trade before the plug was pulled by Deloitte’s aborted audit was $18.93 a share implying a $1.1 billion market cap (last trade I could find : 8 cents). It wouldn’t shock me if Qihoo collapsed in the same, shocking fashion.

I’m not implying that Qihoo is or isn’t a fraud, although for the record the bulls I’ve spoken to have never confirmed to me their revenue model, or that they’ve even confirmed that customers actually pay the 200 to 250K RMB a month Qihoo’s management claims is the going rate for a top level link.

What I am pointing out is that, unlike virtually all the ‘battleground’ stocks I track, Qihoo is giving the shorts a golden opportunity to enter the trade-  if you believe the thesis. Its been a long time since I’ve seen a ‘battleground’ name involving  top-tier shorts trade at a price that practically begs you to do the homework and enter the trade.

Skepticism is the currency of a trader who can survive a twisted tape. Qihoo is a very difficult stock to borrow, and trading in size makes it hard to get in and out of positions easily. I’ve spoken to all the major players in the names I could identify, and it seems to this trader that its’ the bulls who ought to be skeptical of management’s claims. But I respect the fact that my confidence threshold can’t possibly approach that of traders who’ve invested months and tens of thousands of dollars researching this name.

What I can add to the debate is the price and sentiment. Its about as bad a time to be a Chinese bear as I’ve seen in the past 6 quarters. Anyone I’ve spoken to outside of the committed Qihoo bears have no patience anymore for high borrow fees, illiquid options and a stock that trades as random as these names get.

But Wall Street desk skepticism doesn’t change the facts on the ground. And the facts on the ground in this case are that serious questions have been raised about the legitimacy of Qihoo’s operations and financials. And the fact is,  if even a fraction of these questions cannot be adequately answered, Qihoo’s stock is going lower, much lower.

As a contrarian by nature, I embrace the trade where I can stack the odds highly in my side’s favor. It may be  a hard trade, it may be one where the exact endpoint isn’t quite known – Qihoo needs to file its yearly financials sometime around April I believe – but its one where the desk jockey’s exhaustion with Chinese frauds works heavily in your favor. While Qihoo’s shareholders are currently in ‘see-no-evil, hear-no-evil’ mode, that type of smooth sailing for Chinese stock  cannot last forever.

I never made big money by being the last one into a trade. I think I’m early here but on the right side of the facts, and most importantly, sentiment. And the fact is, as Qihoo approaches its audit, you can be sure that the pressure will be on Deloitte to get the job done right. At a certain point before then, although I don’t know exactly when, the market will stand up and take notice of the risks inherent in passing or failing the audit.

And I strongly doubt when that time comes this stock will be anywhere near $17.

At the time of this article the author was short Qihoo