A Conversation with USEG Management

Today I spoke with U.S. Energy Corp. (NASDAQ: USEG) CEO Keith Larsen, CFO Scott Lorimer, and Director of Investor Relations Reggie Larsen, who initiated the call. Some notes from the conversation follow.

- The Brigham Exploration (NASDAQ: BEXP) is intended to make USEG profitable as an oil company alone. CEO Keith Larsen said the company looked at about a hundred oil deals, and looked closely at ten, before picking this one.

- Estimated cumulative revenue from the first six wells (assuming oil prices stay at about ~$70 per barrel) is $1.7 million to $2 million per month, dropping off to about $1 million per month after a year of production.


- USEG is close to a financing deal that will let it borrow $15 million against its Remington Village development at about 5.5% interest. This money may be used for follow up investments in the Bakken field with BEXP. Occupancy there has drifted below 90%, but the management is working to get it back up (by allowing pets, etc.).

- Keith Larsen predicted that USEG's investment in Standard Steam Trust would be a ten-bagger within two years. He noted the advantages of Geothermal versus other alternatives such as solar and wind (Geothermal's always on, so it doesn't need a back up power source), and mentioned that a Canadian geothermal company, Magma Energy recently raised over $100 million in an IPO.

- Re the molybdenum project, Keith and Reggie said that they've been moving forward with preliminary steps on it, but have eschewed publicizing most of them to avoid stirring up the vocal radical environmental opposition. They noted that local blue collar workers have stopped by their offices looking for work, expressing support in the mine project, and asking what they could do to help make it happen. With a weak economy, opposition to the creation of numerous high-paying jobs may lose some political valence.

USEG News

Shares of U.S. Energy Corp. (NASDAQ: USEG) rose about 32% today on about 13x average volume on the news that the company had entered into a drilling participation agreement with Brigham Exploration (NASDAQ: BEXP) in the Bakken oil field. From the release:

"We are delighted to be teaming up with one of the best and most technologically advanced operators in the Bakken oil field," stated Mark Larsen, President of U.S. Energy. "Brigham has proven itself to be one of the premier companies in the Williston Basin through the advancement of their multi-stage frac completions and their consistent improvement of production rates. We look forward to a long term relationship with Brigham and developing low cost reserves well into the future," he added.

"Our patient search for a sound investment in oil and gas has now come to light with today's announcement," stated Keith Larsen, CEO of U.S. Energy Corp. "At a time when natural gas appears to be poised for an extended period of low prices our main focus has been to expand our oil production and reserves. This agreement does just that by providing us with the potential to rapidly expand our oil production and increase our reserves by participating with an experienced operator that has a track record of lowering its finding and development costs. Furthermore, I am confident that our drilling schedule for the balance of 2009 will allow us to reach our corporate production goal of 7,000 MCFED or approximately 1,200 BOED by year end," he added.

This is a pretty large commitment by USEG -- according to the press release, USEG's "expenditures are anticipated to approximate $17.6 million for the first six initial well program." That's a little less than half of USEG's remaining cash and Treasuries, going by the company's most recent balance sheet. Judging by the relative performance of USEG and BEXP today though, without drilling down further, I'd assume this deal is on pretty favorable terms to USEG. Which would make sense, since it appears that BEXP had a more acute need for the cash than USEG had for the participation deal. I'd venture that some BEXP shareholders bought into USEG today.

I got a voice mail about this today from Reggie Larsen at USEG, but we didn't get a chacne to speak. If he and I connect tomorrow, I'll update this post accordingly. Investor relations via social media: just like in those trendy marketing books.

Alloy Steel's 10-Q

The company (OTC BB: AYSI.OB) swung to a loss of ($437,951) on sales of $1,307,160 in the quarter ending June 30^th, but the 10-Q includes this news:

The Company has recently been advised of its successful tender for a significant contract with BHP Billiton Ltd, with the first order release being received by the Company to the value of approximately $3,200,000 subsequent to the reporting date.

Alloy Steel was also the subject of this longer, recent post.

Zinc Again

The collapse in zinc prices last year lead to some mining companies closing their zinc mines. Yesterday, Reuters reported that Hudbay Minerals (TSX: HBM.TO) was considering reopening a zinc mine, "HudBay eyeing restart of Chisel mine-CEO":

TORONTO, June 9 (Reuters) - HudBay Minerals (HBM.TO) could restart its Chisel North zinc mine in Manitoba if the metal's price increase another 10 or 15 percent from its current level, the company's chief executive said on Tuesday.

HudBay shut Chisel North and its Balmat zinc mine in New York last year after zinc prices fell below 50 cents a pound late last year, after topping $2 a pound in 2006.

Cash zinc MZN0 was around 71 cents a pound on Tuesday.

"We think a 10 to 15 percent increase from that price and we will be looking seriously of reopening Chisel, which can be done very quickly indeed," Jones said at a mining conference in Toronto.

That suggests a zinc price of 78 cents to 82 cents a pound would be needed to consider reopening the mine.

Hudbay was prudent enough to have accumulated large war chest of net cash (equal to about a third of its market cap at the time) by the time commodity prices collapsed last year, so it has been able to weather the downturn.

The (modest, so far) rebound in zinc prices this year may be another data point in support of James Kynge's "China Continental" thesis.

Bright Lights, Peak Oil

Hat tip to Aaron Edelheit (with a second assist to Paul Kedrosky) for this article by Chris Turner in the Walrus magazine (which looks like a Canadian version of the Atlantic magazine before the Atlantic's recent, garish redesign): "An Inconvenient Talk: Dave Hughes's guide to the end of the fossil fuel age".

From this article, Dave Hughes, a geologist/doomsayer, appears to be Canada's answer to Matt Simmons. For some reason (perhaps in tribute to the upcoming 25^th anniversary of Jay McInerney's novel Bright Lights, Big City) Chris Turner refers to himself in this article in the second person. Here's a taste:

Dave had to start out fifteen minutes earlier than the requisite ungodly hour so he could pick you up at your house. So you wouldn’t drive yourself. Save a few hydrocarbons, he’d joked. He’s a coal man, a geologist, and he always refers to the holy trinity of fossil fuels whose flames have stoked the past 200 years of industrial growth — coal, natural gas, and especially oil — in that same semi-technical way: hydrocarbons. Dave Hughes has a lot to say about hydrocarbons, mainly how there’s no possible way to keep running the engine of a modern global economy for much longer at the pace we’re burning them. Which is why you felt compelled to join him in the black chill of this late-autumn morning. Because that seems like a pretty big deal.

The uninspired photo above of Dave Hughes (that's the best backdrop they could come up with in Calgary and its environs?) accompanies the article and is credited to "Wilkosz + Way".

China's Economic Transition

China's exports were down 22.6% year-over-year in April, continuing a six month negative trend. That's the obvious cloud in China's economic forecast, but in an article in yesterday's Financial Times ("Chinese tap an inner dynamic to drive growth"), James Kynge highlighted the silver lining:

Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China's case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world's fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to "China Continental" - the transition of the world's most populous country into an increasingly self-propelling economic force. There are caveats, of course, but first the evidence.

Retail sales have held up much better in China this year than in other big economies, growing at a real 15.9 per cent in March year-on-year. But more important than the overall trend is the composition of the retail spending.

The most robust consumer spending figures are coming from inland and lower-tier cities rather than from the traditional growth powerhouses clustered around the Yangtze and Pearl river deltas.

Kynge also notes another sign of this transition, "that domestically bound cargo traffic through ports is increasing year-on-year, while foreign trade volumes are slumping".

The photo above, of a Wal-Mart in Chongqing, comes from the USDA's Foreign Agricultural Service. Chongqing is one of the lower tier cities Kynge referred to in his article.

Alloy Steel's 10-Q

Alloy Steel International (OTC BB: AYSI.OB) filed its 10-Q today (summary; full filing). Another break-even quarter: $39,000 of net income on $1,479,774 of sales. As I mentioned in a recent post ("Run Silent, Run Deep"), I had expected a loss this quarter, so I'm (mildly) pleasantly surprised the company was able to break even during what might turn out to have been the worst quarter of the current global recession. Judging from the price action today though, others had higher expectations. Management offered this comment on the quarter and the company's prospects going forward:

The decrease in sales for the period is representative of the general downturn being experienced in the world economy. The number of orders received by the Company have declined as demand for our product reduced as various mining companies announced that new mining projects were being delayed and/or existing mining projects were being wound back until demand for commodities increased. The Company has submitted tenders for the supply of Arcoplate where possible and is confident that these will be successful with orders likely to be received in the next three to six months. The Company has continued to promote its product in the market place as a superior option for maintenance, as well as seeking entry into other markets which were previously limited by the Company’s ability to meet the demand existing prior to the economic downturn. The Company is confident of being able to present its product well in these new markets, and anticipates additional orders will be generated from these new locations.

Updated Altman Z-Score for Alloy Steel

In a previous post ("Using the Altman Z-Score to Calculate the Risk of a Company Going Bankrupt"), we described the Altman Z-Score model for manufacturing companies:

The Altman Z-Score is a model developed in 1968 by NYU Finance professor Edward Altman (pictured above) to predict the likelihood of a company going bankrupt within the next two years. According to Investopedia,

[R]eal world application of the Z-Score successfully predicted 72% of corporate bankruptcies two years prior to these companies filing for Chapter 7"

In creating the Z-Score model, Professor Altman studied an initial sample of 66 firms, half of which had gone bankrupt, and looked for the balance sheet and income statement ratios that had the most predictive value. Dr. Altman settled on these five ratios¹:

T₁ = Working Capital / Total Assets
T₂ = Retained Earnings / Total Assets
T₃ = Earnings Before Interest and Taxes / Total Assets
T₄ = Market Value of Equity / Total Liabilities
T₅ = Sales/ Total Assets

He then assigned weightings to them based on their predictive values to create his model:

Z Score Bankruptcy Model:

Z = 1.2T₁ + 1.4T₂ + 3.3T₃ + .6T₄ + .999T₅

Based on this model, a Z-score below 1.8 means bankruptcy is likely within two years; a Z-score between 1.8 and 2.99 is a gray area; and a Z-score above 2.99 means there is little likelihood of bankruptcy within the next two years.

In that post, we noted that the Altman Z-Score for Alloy Steel at the time was 4.89. I re-ran the calculation today using the updated numbers and got an Altman Z-Score of 4.19. Unsurprisingly, it's lower than last time, given the drop off in sales and earnings, but still well above the 2.99 level, above which the model predicts little likelihood of bankruptcy within the next two years.

Gaseous Anomaly?

This is a one year chart comparing the U.S. Natural Gas ETF (NYSE: UNG) to a Gulf Coast natural gas¹ royalty trust I own a few shares of, Tidelands Royalty Trust (OTC BB: TIRTZ.OB):



And this is a three month chart comparing them:



It makes sense for the share price of the royalty trust to decline as natural gas prices have declined (the natural gas ETF closely tracks natural gas prices), but I don't know what the explanation is for the recent divergence. It is possible, of course, that the trust's distributions could rise if an increase in production outweighs the drop in natural gas prices, but I don't know of any estimates of future production increases for this trust.

¹About 90% of this trust's royalties come from natural gas production, with the balance coming from oil production.

Run Silent, Run Deep

That is, of course, the title of one of the classic submarine movies¹, but it's also a fitting description of the current investor relations tack of Alloy Steel International (OTC BB: AYSI.OB): as the company's stock price has dived, the company has refrained from releasing any information since its last 10-Q. Over the last few weeks, I tried contacting the company's CEO (who has designated himself the investor relations contact) via the company's website and then via his company e-mail address. After no luck, I trying calling him. Alloy Steel's receptionist in Malaga mentioned he was traveling overseas and, assuming he hadn't had a chance to check his company e-mail address, gave me his personal e-mail address and suggested I try him there. Again, no response. This week, after calling the company's headquarters again and learning that the CEO was again traveling overseas, I sent him the following message:

I understand from Melanie in your Malaga office that you are traveling overseas again. Given your heavy travel schedule and extensive responsibilities, I imagine you must have little time to answer questions from investors. Nevertheless, you have designated yourself as the investor relations contact for your company. Have you considered delegating this role to someone who might have the time to respond to an occasional investor e-mail or phone call?

And received the following response:

Dear Dave.
As a result of the market volatility and the short sellers that have been short selling our stock the board has decided to only release information through the normal reporting channels there will be no separate reports to any investor who we have no record of in our share register.

Kind Regards.
Gene Kostecki
CEO Alloy Steel Int.

Sent via BlackBerry® from Vodafone

This response didn't inspire a lot of confidence in the company's current situation. I can understand the reluctance to communicate with an individual shareholder on Reg FD grounds, but if Mr. Kostecki believes that the market's opinion of his company's prospects is unjustly negative, the best way to counter that would be to release information through "normal reporting channels" proving it wrong. For example, if the company picked up a major order recently, or an order in a new market, it could announce that via an 8-K (as it has done in the past). Since Alloy Steel hasn't released any such updates this year, it's rational for market participants to assume that it has no good news to report.

Judging from the CEO's e-mail above, the break-even numbers it reported last quarter, and its high inventory levels over the last two quarters, my guess is that it will post a loss for the quarter that ended on March 31^st.

I was going to end this post on a positive note, by including a link to Goldman Sachs chief economist Jim O'Neil's column in the Financial Times Thursday, in which he mentioned he had revised upward his growth estimates for China's economy this year and next. If O'Neil's estimates come to pass, that would be good news going forward for mining companies, and, by extension, for Alloy Steel. Unfortunately, after 20 minutes of trying, I was unable to find a link to O'Neil's column using the Financial Times website's search feature.

¹The all time champ of submarine movies is Das Boot, in my opinion.

Applying the Altman Z-Score Model to Mining Companies

Tools and ideas for short sellers, including an automated calculator and screener based on the Altman models.

In a couple of recent posts ("Using the Altman Z-Score Model to Calculate the Risk of a Company Going Bankrupt" and "Applying the Altman Z-Score Model to a Non-Manufacturing Company") we discussed the use of the original, five variable model for manufacturers and the modified model for non-manufacturers. Recall that the modified Altman Z-score model for non-manufacturers excludes the fifth variable in the original model (sales/total assets), to account for different levels of capital intensiveness among non-manufacturers.

Since mining companies, like manufacturers, are also capital intensive, I asked Dr. Altman via e-mail which of his models would be best for miners. His response:

Try both, but probably the 4 variable model is more appropriate.

The photo above, of a copper smelter, is from the website of the Canadian mining company Hudbay Minerals.

Daewoo's Madagascar Deal Nixed

In a post last fall ("An Unprecedented Investment in Food Security"), we noted the report by the Financial Times that the Korean conglomerate had leased half the arable land on Madagascar for industrial farming. Yesterday, the Financial Times reported that that deal has been nixed ("Madagascar scraps Daewoo farm deal"). Excerpt:

South Korea’s project to transform Madagascar into its breadbasket, branded by some as neo-colonial, came to an abrupt end on Wednesday when the Indian Ocean island’s new president said he would shelve the plan.

Daewoo Logistic’s deal to lease a huge tract of farmland, half the size of Belgium, to grow food crops to send back to Seoul was a source of popular resentment that contributed to the fall of Marc Ravalomanana, the former president.

Andry Rajoelina, who was declared president by the military and constitutional court after months of demonstrations and who will be formally sworn in on Saturday, said that Daewoo’s plan was “cancelled”.

Pabrai's New Buys

In a recent post ("Mohnish, How Are You Feeling?"), we linked to Mohnish Pabrai's annual investor letter in which he wrote that he had invested in a number of businesses in the commodities sector in 4Q08. On Seeking Alpha, Davy Bui lists Pabrai's new positions (Hat Tip: The Guru Five):

Pabrai's new positions can be summed up as a bunch of commodities with a hint of financials. New mining stakes include Horsehead Holding Corp (ZINC), Teck Cominco (TCK) and indirectly, Leucadia National (LUK). He also moved into the agriculture space with Potash (POT) and Cresud SA (CRESY). He also added a good-sized position in Goldman Sachs (GS), which received a well-publicized capital boost from Pabrai's acknowledged idol, Warren Buffett. Pabrai completely divested his WCG position and massively reduced stakes in Buffett's Berkshire, Cryptologic (CRYP), CompuCredit (CCRT) and Fairfax Financial (FFH).