EPM

EVOLUTION PETROLEUM (EPM) (Speculative Issue based on market cap and nature of business) May 2007

Investment/Trade rationale:
1)Evolution Petroleum (EPM) is an oil and gas company with a strategic opportunity in enhanced oil-recovery methods. Stock ownership is currently made of a majority of insider shareholders (14% Management + 46% Non Management Directors) and there is upside potential in the stock as the company becomes better known among institutional investors (current market cap=$79.4 Million), particularly given the strength of energy related commodity pricing (oil and gas).
2) EPM is backed by assets and has entered into favorable arrangements (see discussion below for factual details).
3) EPM operates a high margin business model. CO2 Enhanced oil recovery per barrel cost is approximately $15 per barrel of oil/cost includes production tax costs. At current prices, the cost structure provides for high margins and strong business fundamentals assuming execution is as the company projects.
4) Strong and experienced management team. Particularly as a result of the technical and unconventional nature of the business model that EPM operates, strong management is very important for the long term success of the company and stock. The company recently brought on Edward Schell as Manager of Drilling and Unconventional Resources (Edward brings 24 years of relevant experience from Anadarko and Union Pacific).
5) Current supply/demand/pricing dynamics for oil and gas.

Key Investment Risks
1) Evolution Petroleum is an unconventional E&P business. There are fundamental business risks associated with the company’s ability to effectively execute on the technical strategy/recovery methods and there is uncertainty with company projections (the company has little performance history to date).
2) EPM is a thinly capitalized micro-cap stock. It will be more difficult to trade in and out of positions (short term) and the stock will be more sensitive to momentum based share price movement. As the share price gains upward momentum, any negative development/news would likely cause sharp (exaggerated) percentage declines in the value of the stock.
3) Meeting any capital needs/dilutive equity offerings. The company has undergone numerous dilutive equity offerings over the past 2 years (based on presentation material, the offerings appear to have been done without damaging shareholder value nor detrimentally impacting investor confidence to date).

4) Commodity pricing risk (although of lesser importance based on the business model and existing cost/pricing structure).

Highlights:
*Headquartered in Houston, Texas, EPM (formerly Natural Gas Systems and formed in 2003/based on current business model) is a petroleum company incorporated in Nevada, engaged primarily in the acquisition, exploitation and development of properties for the production of crude oil and natural gas. EPM acquires established oil and gas properties and exploits them through the application of conventional and specialized technology to increase production and/or recoveries.
*EPM’s business is grounded on the premise that many oil and gas fields discovered, developed and produced primarily before the 1970's offer the potential of re-entering, restoring production and/or replacing wells with significant amounts of economically recoverable reserves. According to the presentation, many if not most fields were found and fully developed prior to the current period of prices consistently above $25 per barrel and modern technology (and many, if not most, of those oil and gas fields reached maturity or abandonment with substantial amounts of residual oil and gas due to low prices, low energy, or old technology.)
*EPM is focused on an overall strategy of acquiring controlling working interests in oil and gas resources within established fields and redeveloping the fields through the application of capital and technology to convert the oil and gas resources into profitable producing reserves. Its strategy is intended to generate scalable development opportunities at normally pressured depths, exhibiting relatively low completion risk, generally longer and more predictable production lives, less expenditures on infrastructure and lower operational risks.
*Within the overall strategy, EPM has established and highlighted three specific business initiatives: 1) Enhanced oil recovery (EOR) using miscible and immiscible gas flooding; 2) Technology based redevelopment of mature oil and gas fields to recover bypassed resources; and 3)Unconventional gas reservoir development using modern stimulation and completion technologies.
Key Assets/Projects
Delhi Field:The Delhi Field is located in northeastern Louisiana about 30 miles west of the Mississippi River. The Field extends about 12 miles in length and the Holt Bryant Unit covers 13,636 acres. Discovered in the mid-1940's, the Delhi Field has cumulatively produced, according to outside engineers, approximately 210 million barrels of oil and substantial quantities of natural gas from approximately 450 wells completed in Tuscaloosa, Paluxy and Glen Rose reservoirs, at depths less than 3,500'. About 190 million barrels of oil have been produced from the Holt Bryant Unit within the Field. About 90% of the wells were plugged and abandoned predominantly in the 1980's and 1990's. At the time of purchase, the Field had declined to a production level of approximately 18 barrels of oil per day from six producing wells.
Evolution Petroleum, sold to Denbury Resources (DNR, a NYSE listed company with $4.9Billion Market capitalization) for $50 million in gross cash proceeds: 1)100% working interest (80% revenue interest) in the Holt Bryant Unit; 2) 75% working interest (60% revenue interest) in certain depths outside of the Holt Bryant Unit within the Delhi Field. Evolution Petroleum now owns: 1) 7.4% royalty (revenue) interest in the Delhi Holt Bryant Unit; 2) 25% reversionary working interest (20% revenue interest) in the Holt Bryant Unit; 3) 25% working interest (20% revenue interest) in certain depths outside of the Holt Bryant Unit The reversionary working interest reverts after DNR receives $200 million of net revenues, less operating expenses, from the 100% working interest (80% revenue interest) in the Holt Bryant Unit. DNR has committed to spend at least $100 million of capital on the project, and no capital expenditures are included in the operating expenses or deducted from their revenues for the calculation of payout. DNR has publicly stated that it projects recovery of 30 – 40 million barrels of oil, net to its ownership and therefore net of any interests held by EPM. The equivalent projected recovery of future oil production, net to EPM’s retained ownership, ranges from 9 million to 15 million barrels of oil. Current estimates by various parties of the original oil-in-place (OOIP) in the Delhi Holt Bryant Unit range from 350 million to 400+ million barrels of oil. Therefore, after subtraction of oil produced to date, estimates of remaining oil in place range from 160 million to 210+ million barrels of oil.
Tullos Field: EPM owns 100% of the working interest in approximately 150 producing oil wells, 18 water disposal wells and approximately 90 nonproducing wells in the Tullos Urania, Colgrade and Crossroads Fields in central Louisiana (the Tullos Field Area). The Tullos Field Area includes several hundred wells owned by EPM and other operators with over 50 million barrels of cumulative oil production since its discovery in 1925. EPM’s wells produce oil with high volumes of water from the Wilcox reservoir at a depth of approximately 1500'. Current oil production is constrained by insufficient water re-injection capacity, and a significant number of wells are not producing due to mechanical reasons. EPM initiated a program of repairing such wells and returning them to production, followed by applying for permits to convert producing wells to water injection and increase overall capacity for disposing of produced water in the Wilcox formation, to allow increased total fluid production and thereby increase oil production.
Net Proved Developed Reserves in Tullos Urania Field area were assigned by Evolution’s outside engineers. In accordance with SEC rules and definitions, outside engineers estimated that 399,000 net barrels of proved developed oil reserves were owned as of July 1, 2005. Evolution believes that additional reserves can be realized through our ongoing development program. Based on purchase prices, and including the proved developed reserves as of July 1, 2005 and net production to the Company's interests prior to that date, the company estimates that Tullos proved developed reserves were purchased at a cost equivalent to $3.65 per barrel of oil.
New Projects
EPM is currently reviewing acquisition and development candidates that fit the following guidlines: 1)Producing or tested reservoirs of depth shallower than 10,000 feet; 2)Low permeability or dual porosity reservoirs, typically evidenced by low annual production declines; 3) Development potential with scale; 4) Fully mature oil fields deeper than 3,000’ with cumulative production of at least 100 MMBO; 5)Fields with mature horizontal wells; 6)Operational control; 7)Concentrated operations - substantial number of wells within a local area; and 8)Value range from $1,000,000 to $100,000,000+

Management
Robert S. Herlin, President, Chief Executive Officer & DirectorMr. Herlin co-founded the Company and served as President, CEO and Director since the inception. He has 26 years of experience in development, mergers and acquisitions, operations and finance. Previously, Mr. Herlin served as Chief Financial Officer and, subsequently, as President and Chief Executive Officer for Benz Energy, Ltd, an oil and gas exploration company focused on 3 D seismic applications. Harvard MBA.

Sterling McDonald, Chief Financial OfficerMr. McDonald joined NGS as Chief Financial Officer in 2003. Since joining us, he has also been responsible for the administrative functions of the Company. From 1999 to 2003, Mr. McDonald acted as an independent consultant and interim Chief Financial Officer to various companies, predominantly in the petroleum sector. From 1997 to 1999, he served as Chief Financial Officer for PetroAmerican Services, a subsidiary of an integrated NYSE-traded oil and gas company.

Daryl Mazzanti, Vice President for OperationsMr. Mazzanti joined EPM in mid-2005 to oversee all field operations. He previously served Anadarko as Manager of U.S. Business Development. As Production Manager, Austin Chalk for Anadarko and its predecessor, UPRC, he managed 1,300 wells with 65 employees and 25,000 boe of daily production. Mr. Mazzanti previously managed operations in the Carthage Field in East Texas and fields in west and south Texas.

Edward Schell, General Manager of Drilling and Unconventional Resources. Recently joined from Anadarko and brings 24 years of related experience.

Institutional Holders Structure
Rubicon Fund Management $3,481,600 (5.08%) AMEX
River Road Asset Management $4,129,072 (6.03%) Shares Outstanding: 26.70Million
Sterling Johnston $837,120 (1.22%) Market Cap: $79.74
GRT Capital $453,120 (0.66%) Float: 10.14 Million
Ameriprise Financial $757,434 (1.11%) Average Daily Volume: 39.980


Disclaimer:
The information contained in this report is based entirely on information available to the public and has been obtained from the company featured herein, as well as other sources, in each case without independent verification. The information featured herein is considered reliable, but cannot be guaranteed as to accuracy or completeness. The information includes certain forward-looking statements within the meaning of Section 21E of the SEC Act of 1934, which may be affected by unforeseen circumstances or certain risks. The reader is hereby advised to review all SEC filings for a more complete description of the Company's business, including the financial statements and all risk factors set forth therein. By accepting and reading this report, the reader hereby acknowledges that neither VirtualHedge Fund, nor any other affiliate thereof makes any representation, either express or implied, as to the accuracy, completeness, fitness for a particular purpose or future results, of any statement contained herein. NeitherVirtual HedgeFund, nor any of its officers, agents or affiliates, accepts any liability whatsoever for any statements made herein, including without limitation any liability for direct, consequential or special damages of any kind or nature.

Company Analysis-Petroquest Energy

PETROQUEST ENERGY (PQ) May 2007
Key Investment/Trade Positives:
1) Petroquest Energy (PQ) has been undergoing a longer term transformation from a Gulf Coast exploration company to one with significant longer life development in East Texas and the Arkoma Basin. A continuation of the improved stability and an “optimal” mix (as per discussion in our Newfield Exploration analysis) of exploration and development should lead to multiple expansion.
2) The company is highly leveraged to progress at the Woodford Shale (located within 20 miles of Newfield Exploration’s activity). Progress in the area has potential for significant upside for the stock (estimated $5-10 per share based on a break up analysis using conservative comparable valuation metrics). However, particularly based on the smaller size of the company, the costs involved are also substantial (estimated at $5MM per well and more than originally budgeted). Based on our analysis, the project has not been over hyped by management and expectations of positive developments (which are looking fairly positive based on Newfield exploration’s work and initial drillings) have not been incorporated into the price of the stock.
3) Petroquest Energy has had consistent operating success and strong price momentum.

Key Investment Risks
1) Despite diversification efforts Petroquest Energy has a heavy reliance on riskier Gulf Coast exploration outcome (its properties are still highly concentrated relative to peers). Riskier short-lived reserves still disproportionately represent volume and production growth.
2) Petroquest Energy has had significant operational success since its turn around in 2002 and has a history of meeting or beating expectations. Any major setbacks (which are not uncommon given industry/business dynamics) could have a disproportionate negative impact on the stock.
3) Exploration risk (concentrated/heavier reliance on riskier short life reserves), flattening production growth, miscalculated assumptions regarding volume, and exploration cost variables.
4) Commodity pricing risk.


Bullet Point Description/Presentation:
*Petroquest is a purely domestic independent oil and gas company with operations in Oklahoma, Texas and the Gulf Coast Basin. The company seeks to grow production, proved reserves, cash flow and earnings at low finding and development costs through a balanced mix of exploration, development and acquisition activities.

*Current domestic oil and natural gas focus is on: 1) East Texas; 2) Arkoma Basin; 3) South Louisiana; and 4) Shallow Gulf.

*The company has a five step growth strategy by way of: 1) optimizing existing production; 2) development drilling; 3) resource play development; 4) strategic acquisitions; and 5) exploration program.

*From 1985 through 2002, PQ focused exclusively in the Gulf Coast Basin with onshore properties principally in southern Louisiana and offshore properties in the shallow waters of the Gulf of Mexico shelf. During 2003 (the “turnaround” period for the company), PQ began implementing its strategic goal of diversifying reserves and production into longer life and lower risk onshore properties in Texas and Oklahoma. PQ also refocused selection processes to reduce average working interest in higher risk projects, shift capital to higher probability onshore wells and mitigate the risks associated with individual wells by expanding drilling programs across multiple basins.

*During the past 2 years, the company has achieved record production, estimated proved reserves, cash flow from operating activities and net income.

*Historical growth for the company has come through drill bit and strategic acquisitions, with an 89% historical drill success rate over an 8 year period.

*The company has had considerable operating success and is considered a top quartile operator among peers. During 8 years it has increased :1) Reserves +33% CAGR; 2) Production +41% CAGR; and 3) Cash Flow +125% CAGR.

Growth Strategy for 2007/2008/Q&A Discussion
*During the Q&A, questions focused on specific projects (see below for factual background) and particularly on the status of the Woodford Shale. It was highlighted that progress at the Woodford Shale represents a key part of the company’s upside potential.

*Management highlighted an emphasis and goal of focusing its reserve base to longer life onshore plays (focusing on Woodford and Cotton Valley) and ultimately reducing the shorter life/riskier Gulf Coast region reserve base to about 25%.




*Sequential emphasis towards the longer reserve life strategy. In Year End 2006, approximately 52% estimated proved reserves were located in longer life basins in Oklahoma and Texas and 48% were located in the shorter life. This compares to 35% of proved reserves in longer life basins in 2003, 45% in 2004 and 50% in 2005. In terms of production diversification, during 2006, 29% of our production was derived from longer life basins versus 30% in 2005, 16% during 2004 and virtually none in 2003.

*PQ continues to seek opportunities to increase its longer life onshore reserves while maintaining some exposure to shorter life, but potentially higher impact Gulf Coast reserves with an ultimate goal of having longer life reserves represent approximately 75% of total estimated proved reserves.

*The company plans to continue several strategies designed to mitigate operating risks. Since 2003, PQ adjusted the working interest it is willing to hold based on the risk level and cost exposure of each project. For example, the company typically reduces working interests in higher risk exploration projects while retaining greater working interests in lower risk development projects. Also, partners agree to pay a disproportionate share of drilling costs relative to their interests.

*PQ expects to continue to actively hedge a portion of our future planned production to mitigate the impact of commodity price fluctuations and achieve more predictable cash flows (approximately 36% currently production currently hedged and targeting 40-50%)

2007 Focus Projects discussed/highlighted during Q&A

*PQ plans to continue focusing on Oklahoma, Texas and the Gulf Coast Basin, and to continue to build scale, particularly in the longer life onshore regions, through drilling and complementary acquisition activities.

*PQ plans to diversify by focusing on striking a balance between lower risk development and exploitation activities and higher risk and higher impact exploration activities. The company also plans to continue to pursue strategic acquisitions aimed at geographically and operationally diversifying its asset base and increasing its inventory of drilling projects.

Gulf Coast Basin/Turtle Bayou Field. During 2006, PQ invested $6.5 million in this field on the drilling of one exploratory well. As a result of this discovery, production from the field averaged over 4 MMcfe per day during 2006, a significant increase from 2005 average daily production. In addition, this discovery added approximately 15 Bcfe of net proved reserves representing a nearly four-fold increase in proved reserves in the field from the beginning of 2006. PQ is evaluating future opportunities, but at present, does not plan to drill any wells in this field during 2007.
Main Pass Block 74. During January 2006, production was restored at this field after being shut-in since September 2004 in order to complete extensive repairs to third party pipelines damaged by Hurricane Ivan. Production from this field averaged 12.6 MMcfe per day during 2006 and represented approximately 18% of our total 2006 production.

Oklahoma/Arkoma Basin/Woodford Shale. During 2006, PQ drilled 77 wells on Oklahoma properties achieving a 92% success rate. PQ invested $33 million in Oklahoma during 2006 or 19% of total 2006 capital expenditures. PQ grew average daily production in 2006 from Oklahoma properties to 9.1 MMcfe, a 98% increase from 2005 average daily production. During late 2006, PQ began initial drilling program to evaluate the Woodford Shale formation on portions of our Oklahoma acreage. During 2007, PQ expects to spend approximately approximately $30++ million in this region on the drilling of a combination of vertical and horizontal wells and the acquisition of 3-D seismic data to target this potentially significant formation.

Texas/Cotton Valley/SE Carthage. During December 2003, PQ acquired working interests in approximately 41,000 acres in this field, which had approximately 80 producing wells. During 2006, PQ invested $38 million on the successful drilling of 13 wells in this field. Net production from this field averaged 11 MMcfe per day during 2006, an approximate 36% increase from 2005 average daily production. During 2007, PQ expects to invest approximately $40 million and drill 15 wells in this field.

Management
Charles Goodson---Chairman, CEO, and President
Michael O. Aldridge---Chief Financial Officer
Daniel G. Fournerate---General Counsel

Institutional Holders Structure
Ingalls & Snyder $47.131Million (7.7%) NYSE
Independence Investment $29.93 Million (6.55%) Shares Outstanding 47.82 Million
Freiss Associates $25.48 Million (4.18%) Float: 39.47 Million
Barclays $24.25 Million (3.98%) Market Cap $555.61 Million
Mellon $23.74 Million (3.90%) Avg Volume: 393,2000
Wellington Management $20.69 Million (3.40%)

Beijing's tax increase impacts Shanghai Index

From Wall Street Journal,

The Chinese government's first direct action to trim a surge of stock-market investment offered another sign of Beijing's growing concern about the run-up and led to the market's second-biggest decline this year, but it may not be enough to cool things down.

Acting on orders from Premier Wen Jiabao's cabinet, China's Ministry of Finance early Wednesday tripled a trading transaction charge, called the stamp tax, to 0.3% from 0.1%, effective immediately. The government is keen to promote the healthy development of the country's securities markets, the official Xinhua news agency said.

In response, Chinese stocks marked a broad-based decline in heavy trading, as the benchmark Shanghai Composite Index finished down 6.5% at 4053.09. It was the worst performance since an 8.8% fall in the index on Feb. 27 that rattled investors world-wide. It was the second-biggest drop since 1999.

Read More...

The impact on US and other markets, thus far, has been somewhat muted. Or, as one WSJ report put it,

"Beijing may want to protect its burgeoning investor class from a major stock
correction, but regulators' latest attempt to tap on the brakes could wind up as
yet another bug splattered on the speeding market's windshield."

Burgers and Steak Indices

Are burgers and steaks good economic predictors? Let's look at 2 indicators -- the Big Mac Index and "The Steakhouse Index".

The Big Mac index is an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. As stated in the Economist, it "seeks to make exchange-rate theory more digestible"... [the] index was introduced by The Economist in September 1986 as a humorous illustration and has been published by that paper annually since then. The index also gave rise to the word burgernomics. ~ wikipedia

The Steakhouse Index
If steak stocks are down. Should we worry about the rest of the economy?

"If you want to understand how high energy prices are impacting the economy, you could spend your days reading the Wall Street Journal or consulting with economists. Or you could go have a really expensive New York strip steak at the Palm or Morton's."

High-end steakhouses have expanded rapidly in recent years thanks to an economic expansion, the popularity of cholesterol-reducing statins such as Lipitor, and the low-carb/high-protein Atkins/South Beach diet crazes. You'll now find outposts of Morton's, Ruth's Chris, and several competitors in all the best suburban strip malls, edge-city shopping districts, and gentrified downtowns.

The financial results of these testosterone-filled cow palaces reveal much about several trends affecting the U.S. economy.

Read more at Slate

Correlation trade is extreme sport for hedge funds

From Reuters,

To strip out the impact of the underlying index, dealers use the concept of correlation, a controversial measure of how the prices of individual components of a portfolio might move given various scenarios such as an individual default or bad news in a particular sector.

Five-year iTraxx correlation is currently around 17 percent, the highest level for 18 months but still below the 22 percent peak seen in April 2005, before the so-called correlation crises sparked by the downgrades of U.S. automakers Ford ... and General Motors...

Correlation is a measure of idiosyncratic risk over systemic risk, and there are no agreed method of measuring it. The general principle is that if correlation is higher, idiosyncratic risk is lower, because it is less likely that an individual company will default.

Continue reading Correlation trade is extreme sport for hedge funds

How Worrisome Is a Negative Saving Rate?

Charles Steindel of the Federal Reserve Bank of New York writes,

"The U.S. personal saving rate’s negative turn in 2005 has raised concerns that Americans may have to curtail their spending and accept a lower standard of living as they pay off rising debts. However, a closer look at saving trends suggests that the risks to household well-being are overstated. The surge in energy costs may have temporarily dampened saving, while the accounting of household income from stock holdings may be skewing saving estimates. Moreover, broad measures of saving have remained positive, and household wealth is on the rise.

Personal saving has been negative since the second quarter of 2005. For 2005 as a whole, current data from the Bureau of Economic Analysis (BEA) show a personal saving rate of -0.4 percent—a figure that dropped to -1.1 percent in 2006. These readings are well below the 1999-2004 average of 2.2 percent, a good deal below the 1993-98 average of 4.6 percent, and considerably below the 1950-92 norms of 8.6 percent.

Negative saving would seem to point to growing indebtedness and, ultimately, a decline in living standards, as Americans tighten their belts to pay off debts. As Mr. Micawber noted in David Copperfield, “Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”

Concerns that negative saving could jeopardize U.S. household well-being suggest that a closer look at the recent saving trends and their sources is warranted. In this edition of Current Issues, we identify some of the forces depressing measured personal saving, examine how broader saving measures have fared, and assess the likelihood that low saving rates will constrain consumer spending and impede growth in the nation’s living standards in the near term."

Read More...

Upcoming changes to our site

VHF News is making some changes to the web site.

1. We're expanding our list of contributors, and,
2. making changes to the physical appearance of the site.

During the next few weeks, please keep an eye out for the additional contributors -- they're excellent! Make sure that your RSS and ATOM subscriptions are up to date. The increased content will include fundamental company insights, market commentary, trading strategies, economic opinions and more.

Market on the move

OK, guys why is the market moving so much higher on PPI and CPI?  This is really unusual since mutual funds have been seeing out flows for most of the year.

Core CPI rises modest 0.2% in July

Reports Marketwatch,

Core consumer inflation eased back in July, rising just 0.2% after four months of 0.3% gains, the Labor Department said Wednesday.

The relatively tame 0.2% increase in core consumer price index could help keep the Federal Reserve on the sidelines at next month's policy meeting if August's inflation data do not worsen.

Core prices - which exclude food and energy costs - have risen 2.7% in the past year, the highest since late 2001. Core inflation is running about a half percentage point above the Fed's comfort zone.

So far in 2006, core prices are rising at a 3.1% annual pace, a key reason why the Fed increased overnight interest rates at 17 straight meetings over two years before pausing last week.

Meanwhile, soaring energy costs pushed the total CPI up 0.4% in July, as expected by economists surveyed by MarketWatch. The economists were expecting core prices to rise 0.3%, although a sizable number were predicting the 0.2% rise that was reported.

The CPI is up 4.1% in the past year, compared with a 4.3% increase in the 12 months ending in June