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FX Energy : The El Gordo Lottery Ticket of Europe

(August 9th, 2012) Over the next month or so a small European gas company is poised to report results that could move this stock 300%. Yet it seems that few care, and fewer still have staked a position on the outcome. I’m one of the few who has. Read on to learn why you ought to consider doing so as well.

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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.


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.


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.


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.


” Concentration is my motto – first honesty, then industry, then concentration. ” Andrew Carnegie